Any novice, even after taking a casual stroll on Dalal Street (as the stock market is lovingly referred to), will start chirping words like valuations, foreign institutional investors, and of course price to earnings ratio, PE.

This is one term, which is most widely used by experts and novices alike to determine the value of a company or for that matter an entire index like, say Sensex.

Simply put it is a ratio of the current market price of a stock to its earnings per share, EPS, and its unit is in 'multiple' or 'times'.

If the market price of a company on a given day is Rs 500 and its EPS is Rs 100 the PE ratio of that stock would be 5.

Importance of PE

While EPS of a company remains the same for a quarter (period of three months) or a year, the stock market price changes everyday and hence the PE ratio also changes.

But why is PE so important? As mentioned above it is a tool to determine the value of a company.

As any stock market analyst will tell you, a low PE stock is considered cheap and hence valuable. A high PE stock on the other hand is assumed to be expensive.

The converse, though, is also true.

Do you think investors, in the example above, are fools to pay Rs 30 for just a rupee earned in profits? An investor or the market (all kinds of investors come together to constitute a market) pays such a high multiple for a stock only if they expect that the stock price will increase in the future.

• Stock market terms you must know

This should not, however, lead one to believe that a high PE stock is a good bet.

One must note that PE is just one of the tools to determine if a stock is cheap or expensive. Stock market research analysts consider a host of other tools in tandem with PE to identify the true value of a stock.

To calculate PE one must be able to calculate the EPS first.

EPS is equal to net profit of a company divided by the number of shares outstanding.

PE problems

However, net profits of a company along with number of outstanding shares vary from one year to another. While a stock split and bonus issue increases the number of shares, a buyback of shares by the company management reduces them.

• All about market caps and stock splits

On the other hand, stock market analysts make a studied guess about the profits of a company by talking to individual companies or by using other technical tools that help them estimate such figures.

Though used by investors in general as a tool to estimate a company's value, PE has certain shortcomings.

For instance, PE values may indicate different things about different sectors. Furthermore, even within the same sector, say banks, a new age private sector bank's PE cannot be compared to a Public Sector Banks's (PSBs') PE. Different dynamics affect these two banking sectors (like a PSB not increasing interest rates on the diktat of the government leading to a fall in its profit).

In the similar manner, PE cannot be used to compare companies belonging to two different sectors. Say, a PE of a stock belonging to the cement sector will not compare with PE of a stock belonging to the information technology (IT) sector.

Does the Sensex also have a PE?

Like for a company, PE can also be calculated for the benchmark index, Sensex, that is made up of 30 stocks.

Wondering how can you have a single PE for 30 stocks? Is it simply the average of individual PEs?

• Sensex? What's that?

Let's try to simplify Sensex PE.

PE is a ratio of the market price and EPS for a company. Now if the same number multiplies the numerator and denominator, the value of this ratio will not change.

For determining the PE for the Sensex, we multiply both the market price and EPS by number of shares outstanding.

Now, PE = market price * number of shares outstanding / EPS* number of shares outstanding

But market price * number of shares outstanding = market capitalisation and

EPS * number of shares outstanding = net profit.

Therefore, PE now becomes equal to market capitalisation divided by net profit.

Now, calculating PE for the Sensex becomes an easy task.

First you calculate the market capitalisation of all 30 stocks of the Sensex and add them.

Then you calculate the net profits of each of the 30 stocks making the Sensex and sum that up.

The ratio of total market cap to total net profit is the Sensex PE!

Let us now calculate the PE of the Sensex as on March 30, 2007, that is, the last day of the financial year 2007.

Since we are calculating the PE for the period gone by it will be called as historical PE. PE calculated for next financial year or any time after that is called as forward PE.

PE for the Sensex

The shares outstanding for each of the 30 stocks were taken from the BSE website.

Since, there is hardly any point in using historical data for EPS, we took the FY07 estimates* from one of the brokerage houses' projections. As this is the simplest way of calculating PE (there are many ways of calculating this ratio), the actual Sensex PE that a reader calculates, may vary from the one we are calculating now.

The point here is not the exactness of the number, but the process in which it is done. The example is attempted to explain the concept mentioned above.

Total market capitalisation           = Sum Of individual market capitalisation

                                                 = Rs 16,25,367 crore

Total net profit (FY07 estimate*)   = Sum of individual net profits

                                                 = Rs 1,17,982 crore

Hence Sensex PE                      = (16,25,367 / 1,17,982)

                                                  = 13.78 times

* Actual net profit figures for financial year 2006-07 are yet to be declared, hence estimates are taken.

While this method gives you the Sensex PE, analysts first calculate the estimated EPS of the Sensex and then they use this to project the Sensex level.

That is they first calculate the EPS and the PE for the Sensex, multiply the two numbers and reach at a Sensex value one-year, two-year, or for that matter any number of years down the line.

For them, Sensex value on March 31, 2008 = Estimated EPS on the same day * estimated PE on the same day.

So next time don't be surprised when an analyst says that the Sensex will reach 15,000 or 16,000 level by the end of March 31, 2008. You know how they did it. 

The author runs a Mumbai-based finance advisory Money Bee Investments. He can be reached at moneybee.finplan@gmail.com.