How to Use P/E Ratio to Find Undervalued Stocks (Peter Lynch's Most Important Rule)

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So series. So in this video we are going to discuss what is the most crucial thing that you should look at when investing any company. And if you have wondered that what makes a company valuable and why it will be more valuable tomorrow than it is today. Well, the answer to all of these questions comes down to earnings and assets but mostly earnings.

So earnings tells you how the company company's value is going to grow over time. So if you look at any of the stock charts, you'll see that the stock price sooner or later move hand in hand or in tandem with the earnings line. In the short term, there can be some anomalies that you could see, but in the long term, the value is always going to catch up to the earnings.

So one thing to understand is that stocks are not lottery tickets. There is a company behind every stock and if the companies does well the stock does well and you need to realize how how good the company is going to do to to improve its earnings and and how the earnings are going to increase in a month in a year or in a next decade.

So that should be the main focus point whenever you are analyzing any of the company. Now there's a famous ratio that you might have heard of which is the PE ratio and it is simply the numerical shorthand of the relationship between the stock price and the earnings of the company. It is calculated as the price of share divided by earnings per share and earnings.

So here we are talking about the last 12 months or the last fiscal year. And it is quite useful to tell whether the company is fairly priced, underpriced or overpriced. So when we say that PE is 10 of any of the companies, it simply means that it is going to take 10 years to get your money back if the earnings remains constant.

Now apart from uh the PE of the company there is a PE of the market as well uh which tells us if the market as a whole is overvalued or not. Now there can be several reasons that market could be overvalued. First is the interest rate. So if the interest rates are cuts or are quite low uh this this signifies that investors have have a lot of money that they can borrow and can put in the stock markets and they are willing to pay more price uh more price of the stock than it is worth today.

So the market is going to be overvalued in general and second uh is during the bull market there is quite optimism among the investors related to to different kind of stocks. So that is a time when when you you will see people buying stocks at a higher price than they are worth. So that is a time the markets can be overvalued.

Now keeping all these things in mind the PE of the company the P of the market you can have an educated guess that if the company is underpriced overpriced or fairly priced and you can make a decision but one other another thing to take care of when you are making an investment decision is the potential of future earnings.

So so predicting future earnings can be quite hard if you don't look at the data. So when you are trying to understand if the future earnings are going to increase maybe let's say in a month or a year or a decade what you should be looking at is the business in general. What are the company's plan to increase its earnings in the future.

Now the five common ways that a companies increases their earnings are reducing costs or raising the price of the product or service, expanding to the new markets or selling more of the product or service in the existing markets and fifth is the closing of the losing operations. So if you understand the business and you understand the the strategy of the company that it is going to take to increase its earnings, you can make an educated guess if the company is going to be worth more in the future or not.

So if we look at the the different categories that we had discussed in the previous videos, we'll see that the PE of slow growers is is the lowest and the fast growers are at its highest. Now the question here is that if the PE ratio of fast growers company is quite high then what is the point of buying the the overpriced companies?

Well we we should compare apples to the apples and oranges to oranges. So if we have a look at the P of a certain company we should be looking at the P of the industry as a whole and the and the other stocks in that same category. So if we are talking about fast growers, so their their PE is generally higher than the other categories of stock and investors are willing to take a substantial gamble on the improved future earnings of those companies.

So the only takeaway here is that that you should be buying companies just take a look at the PE as well. You should not buy companies that have excessively high PES and and have a look at the earnings and company's plans to increase earnings because in the end stock price is going to catch up with the earnings in the long run.

So this was the whole discussion about the earnings and in the next video we'll be discussing about how we can research more of a stock by looking at the balance sheet and the business models. So that's it for today. See you in the next one.