P/E ratio is one of the most popular parameters among stock market investors who believe in fundamental analysis. Investors assume higher the P/E value, lower the chances of growth and lower the P/E, higher the chances of growth. In our investigation we found it is a myth rather than reality.

P/E stands for Price by EPS (Earnings per shares). As long as EPS is constant and all companies in purview have the same health, conclusion based on P/E ratio will be meaningful. Let me explain this by example. Two companies ‘A’ and ‘B’ performed identically and they generated same profit for each stock (say Rs.10). At present, stock of company ‘A’ is trading at Rs.100 per share while ‘B’ is trading at Rs.120. Assuming that next year again both companies are going to perform similarly then it means that if the investor is going to put Rs.100 with ‘A’ or Rs.120 with ‘B’ both are going to yield Rs.10 only. Of course, it makes sense for the investor to go and buy company A’s stocks.

In reality, two companies are never identical even if they are showing the same EPS. A company which might have invested in some advance machinery installation and has reduced the EPS in the current financial year has brighter chance to perform in coming years. On the other hand another company might have overused its current setup which needs significant maintenance (or replacement) in coming years or the company's sales team might have sold the goods with false promises to customers due to unreasonable sales target pressure. Sales team is on the way to leave the company and customers are going to crib about the product and services in near future. It means good EPS is about to turn bad.

We have illustrated the above hypothesis in the following table

Company	A	B	C
Stock Price(March’12)	120	100	80
EPS (March’12)	10	10	10
P/E(March’12)	12	10	8
Management Actions & Events	During financial year 2011-12, company has invested in advance machinery installation which is going to start production next year. Company has also spent significant money on employee skills enhancement training program.	Not any significant action or event.	Over burned sales team is now leaving the company. Production department is in stress (because sales team has made unreasonable promises about feature and quality to customers). Customers are cribbing about gap between promise and delivery.
EPS (March’13)	12	10	8
Stock Price (March’13)	150	100	60
P/E (March’13)	12.5	10	7.5

Above table is showing on March’12 , company ‘C’ appeared more lucrative to buy from P/E perspective while ‘A’ was the least (because all of them had the same EPS). Probably, big investors who were well informed about the management actions and events had already valued company ‘A’ on higher side. Decision made by big investors is showing that ‘A’ is less lucrative (due to high price).

Ultimately, management actions and events were reflected in terms of EPS. By the end of 2012-13 ‘C’ performed less than previous year while ‘A’ performed better than previous year. Better EPS means better price of the stock. Industry standard benchmark is showing P/E value at 10 (represented by event & action neutral company ‘B’). In spite of the fact that company ‘A’ is at P/E ratio 12.5 (above benchmark) then also investors are ready to pay more to ‘A’. Now, investors have less confidence in company ‘C’ and it is mapped with price matching to P/E ratio 7.5 (below benchmark).

We verified the above theoretical concept with real data. In our verification process we selected BSE200 stocks from 6 leading sectors. Then we selected top 5 and bottom 5 performers (during financial year 2012-2013) in those sectors. We have also tabulated the value of P/E recorded during start of financial year 2012-13. Following tables have summarized our findings.

Sector: Banking & Finance


Sector: Power


Sector: FMCG


Sector: Information Technologies


Sector: Minerals, Metals & Transports


Sector: Pharmaceuticals


We can clearly see, stock price growth and P/E have no evident co-relation. In fact in most of the cases low P/E ratio companies have performed worst while often better P/E companies had done better than other companies in their sector.

Conclusion: P/E parameter is not a silver bullet tool to invest. It is one of the parameters from fundamental analysis school, which is much larger than this one attribute. So, investors who are investing based on P/E ratio are under false sense of security that their investment will perform better.

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