Determining the investable Price-to-Earnings (P/E) ratio is one of the most critical aspects of stock analysis for value investors. Even a fundamentally strong company can turn into a poor investment if purchased at an overvalued price. Therefore, every investor must assess whether a stock’s current valuation is reasonable or overpriced.

This article presents four key principles to help value investors decide on the investable P/E ratio for a stock, ensuring they make informed and profitable investment decisions.

Understanding the P/E Ratio

The P/E ratio is the most commonly used valuation metric, calculated as:P/E Ratio=Current Market Price (CMP)Earnings Per Share (EPS)\text{P/E Ratio} = \frac{\text{Current Market Price (CMP)}}{\text{Earnings Per Share (EPS)}}P/E Ratio=Earnings Per Share (EPS)Current Market Price (CMP)​

It represents the price an investor is paying for every ₹1 of earnings generated by the company.

📌 Example:

• If a stock has a P/E ratio of 10, an investor pays ₹10 for every ₹1 of earnings.
• If the P/E ratio is 20, the investor pays ₹20 for the same ₹1 in earnings.

A higher P/E ratio indicates a higher valuation, making it essential for investors to assess whether the price is justified.

4 Key Factors in Determining the Ideal P/E Ratio for a Stock

Deciding the ideal Price-to-Earnings (P/E) ratio is crucial for investors looking to make well-informed stock purchases. Various factors influence a stock’s valuation, but four key elements play a significant role in determining whether a stock is worth buying at a given P/E ratio:

1️⃣ Prevailing Interest Rates in the Economy
2️⃣ Competitive Advantage (Moat) of the Company
3️⃣ Investor’s Circle of Competence
4️⃣ Stable Business Premium

These factors help investors assess the maximum P/E ratio they should pay for a stock, ensuring they invest at a reasonable valuation.

If you haven’t already, consider reading 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing for a deeper understanding of valuation principles.

1️⃣ Prevailing Interest Rates in the Economy

Interest rates have a significant impact on stock prices and business performance.

📉 When interest rates are low:

• Debt investments (e.g., bonds, fixed deposits) offer lower returns.
• Investors shift money into equities, pushing stock prices higher.
• Companies benefit from cheaper loans, boosting earnings growth and valuations.

📈 When interest rates are high:

• Debt investments become attractive due to higher yields.
• Investors withdraw funds from the stock market, depressing stock prices.
• Companies face higher borrowing costs, reducing profit margins and valuations.

To bring objectivity to this concept, Benjamin Graham’s Margin of Safety approach can be used with

Earnings Yield (EY): Earnings Yield=EPSCurrent Market Price (CMP)\text{Earnings Yield} = \frac{\text{EPS}}{\text{Current Market Price (CMP)}}Earnings Yield=Current Market Price (CMP)EPS​

EY is the inverse of the P/E ratio (EY = 1/P.E.), indicating the return an investor gets per ₹1 invested.

How to Use Interest Rates to Determine the Ideal P/E Ratio

Comparing EY with the Government Securities (G-Sec) Yield provides insights into valuation:

✔ If EY > G-Sec Yield, the stock is relatively undervalued.
❌ If EY < G-Sec Yield, the stock may be overvalued.

Example:

• If G-Sec Yield = 10%, an investor may set the maximum P/E ratio at 10 (1/10%).
• If G-Sec Yield drops to 8%, the investor may be willing to pay P/E of 12.5 (1/8%).
• If G-Sec Yield rises to 12.5%, the investor should only pay P/E of 8 (1/12.5%).

This approach helps investors decide when a stock is cheap, fairly valued, or expensive based on prevailing interest rates.

2️⃣ Competitive Advantage (Moat) of the Company

A company’s economic moat—its ability to sustain competitive advantages—directly affects the P/E ratio investors are willing to pay.

✔ Companies with strong moats (e.g., monopolies, brand power, cost advantages) justify higher P/E ratios.
✔ Companies in highly competitive industries may not sustain profits, making high P/E ratios risky.

Examples of Moats:

• Patents & Intellectual Property (e.g., Pharmaceutical companies)
• Strong Brand Loyalty (e.g., Apple, Nestlé)
• Cost Leadership (e.g., D-Mart, Walmart)

Stocks with stronger moats often trade at a premium P/E ratio due to consistent earnings growth and lower business risk.

3️⃣ Investor’s Circle of Competence

The circle of competence refers to an investor’s expertise in a particular industry or company.

✔ Investing within your area of expertise helps accurately assess risks and valuations.
✔ Avoid overpaying for stocks in industries you don’t understand, even if they have high growth potential.

🔹 Example: A software engineer may better understand SaaS companies and determine when they are overvalued or undervalued compared to traditional industries like manufacturing.

A stock may seem cheap based on historical P/E averages, but without a deep understanding of its business, an investor may miss risks that justify a lower P/E ratio.

4️⃣ Stable Business Premium

Some businesses command higher P/E ratios due to stable cash flows, low cyclicality, and strong governance.

✔ Stable businesses (e.g., FMCG, utilities, consumer staples) justify higher P/E ratios.
✔ Cyclical businesses (e.g., real estate, commodities, auto) may not sustain high P/E multiples.

Example:

• HUL (FMCG) typically trades at P/E 50+ due to consistent demand for its products.
• Tata Steel (Cyclical) trades at lower P/E ratios because profits fluctuate with commodity cycles.

Investors should adjust their ideal P/E ratio expectations based on the nature of the business they are evaluating.

Key Takeaways

📌 The ideal P/E ratio varies based on:
✅ Interest Rates → Higher rates = Lower P/E, Lower rates = Higher P/E
✅ Competitive Moat → Strong moats justify premium P/E ratios
✅ Circle of Competence → Only invest in industries you understand
✅ Business Stability → Consistent businesses command higher valuations

By applying these four factors, investors can develop a more structured approach to deciding the maximum P/E ratio they should pay for a stock.

Readers’ FAQs: Understanding the Price-to-Earnings Ratio (P/E Ratio)

Q: Should We Pay a High P/E for Stocks with a Competitive Advantage or Moat?

A: When investing in high P/E stocks (above 25), many factors must align for good returns. There is no precise way to determine whether a stock should have a P/E of 30, 45, or 60. However, even a perception of slowing growth—not just an actual slowdown—can reduce the P/E multiple and affect investor returns relative to EPS growth.

The margin of safety in high P/E investments is often lower, increasing the probability of negative surprises. While some investors have profited from high-growth stocks at high valuations, we prefer to invest where we have a margin of safety.

For those interested in growth investing, Philip Fisher’s Common Stocks and Uncommon Profits offers insights into this approach. Ultimately, investors should adopt a strategy that aligns with their comfort level and risk tolerance.

Recommended Reading:

• How to Earn High Returns at Low Risk – Invest in Low P/E Stocks
• Hidden Risk of Investing in High P/E Stocks
• 3 Simple Ways to Assess Margin of Safety in Stock Investing

Q: How can we determine the minimum P/E ratio a stock should have based on fundamentals?

A: The P/E ratio depends on multiple factors, including earnings consistency, capital structure, market sentiment, promoter perception, brand image, and liquidity. Some of these, like earnings consistency, are stable, while others, such as market sentiment, are highly volatile.

Predicting a fixed P/E ratio is uncertain. This is why we do not assign target prices or intrinsic values. Instead, we prefer buying strong stocks at a low P/E to ensure a margin of safety. We recommend avoiding speculative high P/E stocks, as they come with hidden risks.

Recommended Reading:

• Hidden Risk of Investing in High P/E Stocks
• How to Earn High Returns at Low Risk: Invest in Low P/E Stocks

Q: Should we use forward P/E or historical P/E for stock valuation?

A: I rely on P/E ratios based on historical earnings rather than forward earnings. Benjamin Graham, in The Intelligent Investor, warns against using forward P/E because analysts’ earnings forecasts are often inaccurate. Studies show that 59% of analysts’ predictions are off by at least 15%, making them unreliable.

Recommended Reading: How to Do Valuation Analysis of a Company

If you haven’t read The Intelligent Investor, I highly recommend it.