The simple PE ratio, an extremely basic calculation, is a measure of valuation which is easily comprehensible to many retail investors. It is simply the price per share divided by the earnings per share. One could also take the market capitalisation of equity and divide it by the total net income of the company and get a similar figure.

A PE that is too high is an indication of overvaluation. A PE that is too low may mean undervaluation. But this is not true in every instance. A high PE stock may still be undervalued while a low PE stock may very well be overvalued. The value of a company is dependent on the future cash flows that the company can produce going forward from this point in time to the future. As such it is important to assess the value of a company by looking at things wholistically.

The corporate actions and decisions of management, the sustainability of earnings or the earnings power and the ability of the company to earn a return in excess of market rates of return all have a part to play in determining the value of a company.

A company whose earnings are cyclical may show up as a low PE stock in your screen. If you were to buy that company today, you may have overpaid for the company. Typically, cyclical companies appear cheapest when they are at the peak of their earnings cycle and expensive when they are near the trough of their earnings cycle.

One way to counter this is using a cyclically adjusted price to earnings ratio which adjusts the PE for these ebbs and flows in the earnings of a company.

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kingsley

I have been an investor for 15 years now and my journey has meandered from Warren Buffett to Ben Graham. My start, like many, really was the naive idea that Buffett's skills could be replicated in some fashion. I was proven wrong when some of the supposed stock picks that I chose had dismal performances. Then, I learnt that it is no point trying to be someone I am not. Gradually, through failure and some success in deep value investing, my approach towards stocks gradually shifted to an approach based around Graham's techniques. So, I give credit where credit is due and to Ben Graham, I and many other investors around the world, owe him a great deal. So, if you want to read up on biographies, read about Ben Graham. His seminal work, Security Analysis is a gem. My books are just rich interpretations of what he has taught.

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