How to check if a stock is overvalued or undervalued? | What is PE Ratio? What is PEG Ratio?

Summary

In this video, Sahil explains the importance of understanding company fundamentals and valuations when investing in the stock market. He introduces the Price-to-Earnings (P/E) ratio as a tool for evaluating stock prices and teaches how to assess whether a stock is overvalued, undervalued, or fairly valued. Sahil also discusses the significance of comparing P/E ratios over time and within industries, alongside the P/E to growth (P/G) ratio for future potential. The video emphasizes in-depth research and warns against making decisions solely based on P/E ratios, offering insights to help identify attractive investment opportunities.

Takeaways

• 😀 Understand that stock valuation is based on two factors: fundamentals of the company and its valuation.
• 😀 Stock price alone doesn't determine whether a company is costly or cheap; the price-to-earnings (P/E) ratio is key.
• 😀 The P/E ratio is calculated by dividing the price per share by earnings per share and helps assess if a stock is overvalued or undervalued.
• 😀 A higher P/E ratio compared to historical averages might suggest a company is overvalued, while a lower P/E could indicate it's undervalued.
• 😀 Always compare a company's current P/E ratio with its historical median P/E to get a sense of its valuation over time.
• 😀 In addition to historical comparisons, it's important to check the P/E ratio of a company's industry for context.
• 😀 The Price-to-Earnings Growth (PEG) ratio helps assess the growth potential of a company by considering its earnings growth relative to its P/E ratio.
• 😀 A PEG ratio of less than 2 is generally considered undervalued or fairly valued, while a PEG ratio greater than 2 might indicate overvaluation.
• 😀 Avoid using P/E ratio when a company is reporting negative earnings, as it doesn't provide meaningful valuation insight in such cases.
• 😀 The P/E ratio may not be reliable in exceptional cases, such as during the COVID-19 pandemic, where external factors impact earnings and stock prices.
• 😀 Do in-depth research before making investment decisions based on P/E ratios, as the market often reacts to future earnings expectations.

Q & A

What is the P/E ratio and how is it calculated?

The P/E ratio, or Price-to-Earnings ratio, is a metric used to assess a company's valuation. It is calculated by dividing the company's share price by its earnings per share (EPS). For example, if the share price is ₹150 and the EPS is ₹5, the P/E ratio would be 30.

Why is the P/E ratio important for stock valuation?

The P/E ratio helps investors assess whether a stock is fairly priced based on its earnings. A higher P/E may indicate high growth expectations, while a lower P/E could suggest the stock is undervalued or that the company is facing challenges.

How can you determine if a company is overvalued or undervalued using the P/E ratio?

To determine if a stock is overvalued or undervalued, compare its current P/E ratio with its historical median P/E ratio over the last 3–5 years. If the current P/E is higher than the median, the stock may be overvalued, and if it is lower, the stock may be undervalued.

What is the median P/E ratio, and why is it useful for evaluation?

The median P/E ratio is the middle value of a company's P/E ratio over a specified period, typically 3–5 years. It helps investors understand the stock's typical valuation and provides a benchmark to evaluate whether the current P/E is too high or low.

Can you give an example of a company that is undervalued based on its P/E ratio?

ITC is an example of a company that is currently undervalued. Its 5-year median P/E ratio is 30.7, but it is trading at a much lower P/E of 19.6, indicating that it is undervalued compared to its historical performance.

How can industry comparisons help in evaluating a company's P/E ratio?

Comparing a company's P/E ratio with other companies in the same industry helps to determine if it is overvalued or undervalued relative to its peers. For example, Infosys can be compared with TCS, Wipro, and HCL to understand its relative market position.

What is the P/E/G ratio, and how is it useful in evaluating stocks?

The P/E/G ratio is calculated by dividing the P/E ratio by the company's expected earnings growth rate. It helps assess whether a high P/E is justified by future growth potential. A P/E/G ratio under 2 is typically considered fair or undervalued, while ratios above 2 may indicate overvaluation.

What does a P/E/G ratio of less than 1 signify?

A P/E/G ratio of less than 1 indicates that the stock is undervalued, as it suggests that the company’s stock price is low relative to its expected future earnings growth. However, such companies are difficult to find.

When should you avoid using the P/E ratio to evaluate a company?

The P/E ratio should not be used when a company's earnings are negative, as it will distort the valuation. Additionally, in exceptional situations like the COVID-19 pandemic, when external factors severely impact earnings, the P/E ratio may not accurately reflect a company's true value.

How can you assess a company’s future earnings if the P/E ratio is skewed by external factors?

In cases where external factors like the pandemic have skewed earnings, investors can estimate future earnings by looking at historical earnings growth trends and assuming a similar growth rate for future periods. This method can help predict a company's recovery and long-term performance.