Valuation: P/E Ratio and Estimating Intrinsic Value

Two companies might both be profitable, but one might be a better investment than the other if you pay less for the same earnings. Valuation is about answering: given the company's profits, growth rate, and risks, what should I reasonably pay for a share?

Price-to-Earnings Ratio (P/E)

P/E = Stock Price / Earnings Per Share. It tells you how many years of earnings you are paying for when you buy a stock. A stock trading at 50 rupees with earnings of 5 rupees per share has a P/E of 10—you're paying 10 years of earnings. A stock at 500 rupees with earnings of 10 rupees per share has a P/E of 50. Is the second stock expensive? Not necessarily—if it's growing earnings faster, the P/E might be justified. But it's riskier; if that growth doesn't materialize, the stock has further to fall.

A company's 'fair' P/E depends on its growth rate, profitability, and industry. High-growth tech companies often trade at P/E ratios above 30 or 40. Mature industries might trade at P/Es below 15. When the overall market is pessimistic, even good companies trade at low P/Es; when the market is euphoric, average companies trade at high P/Es.

Intrinsic Value

Intrinsic value is a rough estimate of what you think a company should be worth based on its cash flows, growth rate, and risk. A simple approach is to estimate the company's sustainable earnings power and apply a reasonable multiple. If a company is earning 10 crore rupees per year and will do so indefinitely (no growth, no decline), and you think a reasonable multiple is 15x earnings, you might estimate intrinsic value at 150 crore rupees, or 50 rupees per share (if there are 3 crore shares outstanding). If the stock is trading at 30 rupees, it might be undervalued; if it's trading at 70 rupees, it might be overvalued.

The catch is that intrinsic value is an estimate, not a fact. Reasonable people can disagree. It's a tool for thinking, not a crystal ball. The best investment practice combines a rough intrinsic value estimate with a margin of safety—you buy only when the stock is trading well below your estimate of what it's worth, giving you room for error.

• Valuation is relative; a high P/E is not automatically bad if growth justifies it.
• The best time to buy is when price falls below intrinsic value plus a margin of safety.
• Intrinsic value estimates change as new information arrives.
• Always buy with a margin of safety; this is your cushion for being wrong.