Why Retail Investors Lose Money on Simply Investing Based on PE Ratio

Over the years I have come across many small retail investors who simply invest in any particular stock or mutual fund based on someone’s suggestion. There are some of them who just simply park their money going by some advertisement. This trend has not only affected their long term returns but also made them lose money on the stock market. There have also been several instances where they often get misguided to pick the right stock based on the technical parameters.

Among all the technical parameters P/E ratio has deceived the small investors the most compared to its peers because of its age-old thumb rule. Now let us understand the PE ratio.

P stands for “Price” and E stands for “Earnings”. When P is divided by E, we get the PE ratio. E.g., if the share price of a company, say “A” is Rs 100 and the company earns Rs 10 per share. Then the PE ratio of the company will be =  (the share price of the company / its earnings per share). In our case, the PE ratio of the company “A” is 10. Thus the PE ratio indicates that the share price of the company “A” is 10X its earnings. So basically PE ratio gives an exact idea about how many times the share price of the company is trading on the stock market compared to its earnings.

How to pick a stock or mutual fund based on the PE ratio?

The age-old thumb rule is we need to purchase that particular stock which has a less PE ratio i.e. Lesser the PE ratio the more discounted the share price is in the stock market. If the PE ratio is high then it means that the price of the share in the stock market is high. Another golden thumb rule in the stock market is always buying cheap and sell high.

Let us understand it by an example. Say Mark has shares of two companies A and B. The market price of company A is Rs. 100 and its earning is Rs. 10. So the PE ratio of A is 10. Whereas the market price of company B is Rs 200 and its earning is Rs. 10. So the PE ratio of B is 20. Going by the thumb rule of P/E ratio, Mark concludes that company B is overvalued since its having a higher PE ratio than Company A. So Mark decides to sell the shares of company B and waits for the market to take its course and make him billionaire one day with the shares of company A.  

But in reality does it happen?

NO, it doesn’t happen always. There are many cases that the opposite happens. Let us understand why.

The small retail investors like Mark, whenever they calculate the PE ratio they do it based on the latest earnings i.e. the earnings posted by the company on the latest past because this is the only information available to them. Whereas the large institutions or fund houses who have a team of researchers calculate the PE ratio not based on the latest earnings but based on projected earnings i.e. on the possible earnings of the company in short term. By this, the big investors purchase the share at cheap rates and sell them at high rates.

Let us understand it by an example. Say there is a big research house named “Creeds AMC” which has deployed a larger number of its research firms who keeps a track on numbers of different companies, meets their management, finds out their upcoming projects, looks for the records of the industry and keeps doing macro/micro analysis on different factors. Now this “Creeds AMC” by its ground research team compares the company A with stock price Rs 100 and it’s latest earning Rs 10 (PE ratio 10) with company B with stock price Rs 200 and it’s latest earning Rs 10 (PE ratio 20) and finds out that the earning of company B will increase from Rs 10 to Rs 40 in future making its projected PE ratio 5  because of its outstanding projected performance. Whereas the earning of company A will decrease from Rs.10 to Rs 5 making its projected PE ratio 20.  Thus “Creeds AMC” buys shares of company B based on its projected PE ratio and in the future makes a big profit from its investment. But our small retail investor Mark who bought the shares based on the latest earning for sure got deceived and booked a loss on his investment.

What should be your approach with PE ratio?

PE ratio is a great tool to pick a stock or a mutual fund if used correctly. From our above example, we can surely say that retail investors should not conclude any stock if they find out its PE ratio is on the higher side. Instead, they need to do some research and find out the projected earning of the company. Thus the calculation of the PE ratio should be based on the projected earning depending on the various factors of the company’s projected future scope and performance.

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