Warren Buffett, one of the world’s most successful investors, follows the philosophy of buying stocks of only those businesses that he understands. Select companies in businesses that you already have an idea of and find interesting. One of the businesses that could be of interest to you would be the one, which you are affiliated to because of your employment. For instance, if you are working in a pharma company, you may understand this business well. 

All companies present details of their financial performance in their Annual Reports[A1] . In case of a company having its Initial Public Offering – IPO (when a company offers its shares to the public for the first time, it is called Initial Public Offering), it is required to publish its past performance in its IPO offer document[A2] . There are also a vast number of research reports published by research and brokerage houses, and company analysis done by the media, which is worth reading, to assess a company’s past performance and future potential. ‘Ratio Analysis’ is widely used to assess a company’s past performance.

Although a company may have performed well in the past, it is not necessary that it will continue performing well in the future. All companies go through business cycles of ups and downs. It is important that you form a view on the future trends of the business the company is a player in. This can be done by reading views of experts in that business/industry and forming your own view by reading and understanding economic trends and the impact of these trends on the company’s business.

As mentioned earlier, the share price of all companies continuously fluctuate on the stock markets with investors buying and selling the shares. The price at which an investor is willing to buy or sell a share of a company is the perceived value of the share of the company taking into consideration the company’s present business and future business growth. In addition to this, investor sentiment plays a large role in pricing of stocks. It is important that before you buy a company’s share, you assess whether the price of the share at which it is available for purchase, is adequately valued i.e. it is not over-priced. Similarly, when you sell, you need to make sure that you are not selling too cheap. To help you assess this, you could use a popular stock market ratio called the Price/Earning ratio (P/E ratio). The P/E ratio is based on the following formula:
 

P/E ratio = Market price of the share
                 Earning per share (EPS)*

*EPS  = Profit After Tax (PAT)
               Total number of shares issued by the company

You can obtain information on the EPS, PAT and total number of shares issued by the company from its annual report.

Let’s understand how the P/E ratio is used with an example:

Company XYZ Ltd. has issued a total of 10 lakh equity shares and has earned a net profit of Rs 10 lakh. The EPS of the company is Re 1. The current market price of the company is Rs 15 per share. The P/E ratio of Company XYZ Ltd will be 15 (Rs 15 / Re 1).

The P/E ratio helps judge by how many times the company’s share is traded based on its earnings. In this case, the company’s stock is available at a multiple of 15 times its earnings. The higher the P/E ratio, the higher is the stock’s valuation. Usually market prices of well-established companies with a good past track record and reputed promoters command a high P/E ratio.

To use the P/E ratio correctly, keep the following aspects in perspective:

• Compare the P/E ratio of a company with that of other companies in the same business.
• Compare it with P/E ratios of the benchmark indices such as the P/E ratio of the BSE Sensex, the NSE Nifty, etc.
• Compare the P/E ratio with the growth potential of the company and the industry it is a part of. There could be a situation that even if the P/E ratio of a company is high, it would be worthwhile to buy the stock if the growth potential is significant.

To conclude, just because a company’s P/E ratio is high, it does not mean that it is over-priced. Consider this ratio along with other factors such as past performance, business potential, promoters, the company’s order book position, etc.