Thread by @money_theory

A thread on Price to earnings ratio:

Today I will try to explain the PE ratio in a simple way. Grab a bar of KitKat and let's get started.

Say, one fine day, you visited the only restaurant that is available in your city for the first time to eat some food.

You are outraged by the food they make. It was terrible, tasteless, and one of the most disappointing lunch you have ever had.

You decided to start your own restaurant with world-class chefs, recipes, and ambiance.

People started rushing to your restaurant for its tasty food coupled with other factors. And your business started to grow.

The business is now making profits of 10 lakhs yearly. You appointed an administrator to take care of it.

You traveled to various places, met different people, experienced different cultures. You are enjoying your life. But an unexpected event occurred.

Your brother in your home country unable to repay the debt of 1 crore he has borrowed. The lenders have been harassing him.

You visited the home and decided to sell your restaurant. A buyer approached and gave in 1 crore. You paid the loan amount and freed your brother.

Ok, where exactly is the PE ratio in this story? You yourself will find it out after seeing the formula.

PE ratio indicates the rupee amount an investor can expect to invest in a business in order to receive one rupee of that business profits.

The formula is PE = Price/Earnings

Looking at the above example, you see that

Price = 1 crore

Earnings = 10 lakhs

This brings the PE ratio to 10 times meaning the buyer has paid 10 times the profits to earn 1 rupee business profits

One notable point here is since we have only one owner there is no concept of shares.

However, in the stock market, the market value of a business is split into millions of shares.

So the formula looks like this

PE ratio = Price per share/Earnings per share

The three big determinants are

Capital needs

Risk

Growth

With all other things remaining equal

A firm with high capital needs gets low PE

(Eg: Tata power)

A risky high debt business gets low PE

(Eg: Vodafone idea)

A fast-growing business gets high PE

(Eg: D-mart)

Common usages:

•Using PE sensitivity analysis

•Comparing with industry peers

•Comparing with the industry average

•Comparing with the historical average

Flaws:

•E in ratio stands for earnings which can be manipulated

•Does not work for cyclicals

•Does not work for loss-making businesses

•One time gain/loss can skew the ratio

•Debt and taxation can skew the ratio

Generally speaking, a high PE ratio indicates high investor expectations towards the stock and vice versa.

To conclude, PE is one of the most important ratios out there. It acts as a great filter to find out undervalued businesses.

That's it, folks. Hope you enjoyed reading. Like & retweet, if you find the thread value-added. Have a great day.