P/E ratio or Price / Earnings ratio is the market price we are paying for each rupee of earning. We can obtain P/E ratio using the below formula.
P/E = Market price of the share/Earnings per share.
If P/E ratio is low, then we are paying less for our gains, and if P/E ratio is high, then we are paying more for the earnings.
To compare the stocks in a particular sector, we have to find peer group companies. For that, we may use http://screener.in as they are giving peer group comparison.
Also, in that comparison, first we have to find the average P/E ratio (or Median P/E ratio) using peer companies P/E, and the stocks with lower P/E than average P/E is considered to undervalue and we can buy that stock. Also, if the stock has higher P/E ratio than the mean P/E ratio then it is considered as overvalued and we can expect the stock price to revert to the average P/E level in the short term.
In simple words,
Stock P/E > Average P/E, then overvalued; so Sell or Short
Stock P/E < Average P/E, then undervalued; so Buy or Long
For example, let us consider the IT industry. TCS is one of the big IT companies. We shall compare the peer companies of TCS in IT sector using screener.in.
Now the average P/E is (17.66+15.77+14.39+15.28+13.3+25.62+13.83)/7 = 16.55
Here the most undervalued stock is TechM and L&T Info so we can buy these two stocks and the most overvalued stock is Oracle Fin Serv and TCS so we can short these stocks. We can compare each sector with the above method to find out the overvalued and undervalued stocks.
How to conclude that the overall market is undervalued or overvalued?
We can take Nifty P/E for this purpose as it expresses the whole market movements. First, we are going to compare Nifty P/E ratio for past periods like 15 to 20 years.
Highest P/E ratios = 28.47(11-Feb-2000), 28.29(8-Jan-2008), 27.69(12-Dec-2007)
Lowest P/E ratios = 10.68(27-Oct-2008), 10.84(12-May-2003), 11.62(1-Jan-1999)
Current P/E ratio = 25.17
Now we can observe from the above data that nifty P/E ratio is near to the high so we have to be cautious to take a long position for an extended period in this level as already market is near to overvalued zone so we can hold old position or start liquidating the stocks. Also, if the Nifty P/E ratio is coming near to 11, then we can start accumulating or buying the shares.
But mass participants in the market used to do this in contrary that they start investing near the top of P/E (overvalued zone) and sell everything near the bottom of P/E (Undervalued zone).
So now the market is near to overvalued area according to P/E ratio, so it is time to be cautious, and this method of comparing historical P/E values to find the overvaluation or undervaluation is considered effective, and it is working out nicely in long term period.