Valuation basics
A great company can be a poor investment if you pay too much for it. Valuation is about the price you pay for what you get.
Price to earnings
The P/E ratio is the share price divided by earnings per share. A P/E of 25 means you pay ₹25 for every ₹1 of annual profit. Higher P/Es reflect higher expected growth, or higher optimism.
Compare a company's P/E with its own history and with similar companies, never in isolation. A bank and a software company are valued very differently.
Earnings per share
₹40
Share price
₹1,000
Earnings yield
4%
The business is identical at every P/E. Only the price you pay for its ₹40 of yearly profit changes.
Growth and price together
A company growing profits 25% a year can deserve a higher P/E than one growing 8%. But if the P/E already assumes years of perfect growth, any disappointment can cut the price sharply even while the business does well.
Margin of safety
Benjamin Graham, the father of value investing, advised buying only when price is comfortably below your estimate of value, leaving a margin of safety for errors. Your estimates will be wrong sometimes; the margin protects you.
If this feels like a lot of work, it is. That's a good reason why most people are better served by diversified index or active funds for the bulk of their money.
Key takeaways
- 1P/E = price ÷ earnings per share.
- 2Compare valuations with history and peers.
- 3Leave a margin of safety for your own errors.
Try it with your own numbers
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Educational content, not investment advice. Figures are illustrative.