What does P/E ratio tells about a stock? Should you buy low P/E stocks or avoid? Find out

Price to Earnings (P/E) Ratio is the ratio of a stock to its earnings per share (EPS). It is one of the most popular valuation metrics of stocks as it indicates whether a stock at its current market price is expensive or cheap.

In general, low P/E stocks tend to be less risky and more defensive in nature, which provides stability during periods of market volatility. There are a number of benefits to investing in low P/E stocks, including the potential for higher returns, lower risk and increased stability. However, investors should carefully analyze and understand why a company is low at its price-to-earnings ratio.

According to Siddharth Oberoi, founder, Prudent Equity, the thinking behind the strategy is that stocks with low P/E are undervalued and have the potential to generate higher returns.

The low P/E ratio segment contains stocks growing at a fast pace with good business advantage and efficient management, he said. Often these companies are in industry sectors that are at a nascent stage of the life cycle.

"Such stocks are yet to be recognized by general market participants and therefore, available at low valuations," he said.

Oberoi also said that on the contrary, this segment also contains stocks that have poor business fundamentals and may have questionable management that has eroded the wealth of shareholders over the years.

He added that a low P/E is in itself not a sufficient barometer to gauge the price attractiveness of a scrip, it is nonetheless an important and reliable one.

As can be seen from the chart, both companies have the same earnings per share (EPS) and growth rates. An increase in the P/E ratio for company B from 8 to 11 times, gives a disproportionate appreciation of 58% in the stock price versus the one with a higher P/E. This, however, assumes that the P/E of company A remains static, being already on the higher side.

Historically, low P/E investing has mostly worked in different levels of the market, he said, adding that one must, however, deliberate the reason why the market has accorded low P/E to a stock. 

"Is it because of any governance issue in the stock, slowing growth rates or any other reason. If there are no such issues, then one can conclude that the market is mispricing the stock."

Rachit Chawla, CEO, Finway FSC, said that most investors might tend to invest in stocks that have a low price-to-earnings ratio, primarily because it means paying less in comparison to the profits earned.

"Low P/E ratio, being a lower price tag, makes it a lucrative option for people to invest in," he said and warned that there is an imperative need to carefully analyze and understand why a company is low at its price-to-earnings ratio.

In other words, the P/E ratio basically informs the investors in ways to determine whether a stock is overvalued or undervalued compared to the specific company’s earnings. It is the ratio to measure how much the market will be paying against the current operations of a company as well as its prospective growth.