P/E Ratio or PE Ratio as they are commonly referred to stands for the Price to Earnings Ratio of a company. In simple terms, it helps an investor calculate the price multiple that investors are willing to pay for a company’s earnings.
PE ratio is the short form of the Price to Earnings ratio.
It is very important to consider this ratio when analyzing the performance of a particular company.
The price-to-earnings (PE) ratio helps in comparing the price of a company’s stock to the earnings the company generates. This comparison helps you understand whether the stock is overvalued or undervalued. Basically, the market price of a stock tells you how much people are willing to pay for the stock but the PE ratio accurately indicates the company’s earnings potential.
Price to earnings (PE Ratio-P/E Ratio) infographics by Kamlesh Rode
What is the PE ratio in the stock market?
Basically, it is an economic ratio usually expressed as a ratio of profit to price. It is basically a technical analysis indicator used by investors to choose whether to buy or sell shares of a company.
The price-to-earnings ratio (PE ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS).
The Price-Earning looks at the relationship between stock price and a company’s earnings. The Price-Earnings multiple is the most popular metric of stock analysis, although it is one of the analyses one should consider.
Simply it is the market price of the share divided by the earning by a single share in that company. Depending on this ratio an investor can judge the price value of the stock. But relying only on this ratio is slightly misleading. For example, if a company sell its asset, then it will reflect in the balance sheet as profit. Actually, it is not the company’s performance. But PE ratio is a simple way to understand the overall performance of an index.
The formula of PE ratio
PE ratio = Market share price/Annual earnings per share (EPS)
Assume there are two companies ‘X’ and ‘Y’, operating in the same sector. If PE of ‘X’ is 30 and PE of ‘Y’ is 22, then ‘Y’ is considered to be a better buy, as the market price has not gone up to reveal the earnings prospects of the company. But ‘X’ is considered to show higher growth prospects as compared to ‘Y’.
What’s an EPS?
Please detailed post on Earnings per share with infographics
Example of PE ratio calculations
PE Ratio =Market price per share ÷ Earnings per share
This is to show how many times the value of a share is trading in the market.
E.g.: EPS (Earnings per share) is Rs.100
And the MPS (market price of share) is Rs.800
Then the PE Ratio is = 800/100 = 8
How to interpret Price-to-earnings (PE) ratio
Generally, a high PE ratio suggests that market participants are bullish on the stock and expect the company to post higher earnings growth going forward. However, it can also be interpreted as an overpriced stock in some cases.
A low PE ratio can either be interpreted as an undervalued stock or market participants are not too bullish on the company’s future earnings growth.
Types of Price-to-earnings (PE) ratio
PE is also of two types namely Trailing PE and Forward PE
Trailing PE is calculated using previous years’ data whereas Forward PE is calculated based on predictions. Hence Trailing PE is considered more authentic.
Forward Price-to-earnings (PE) ratio
Forward PE ratio is calculated as the close price of the stock divided by estimated earnings per share of the company for the current financial year. If the current stock price is Rs.300 and the estimated EPS of the company for the current financial year is Rs.8, then the forward PE ratio is 300/8 = 37.5
Forward PE ratio can be used to compare it with the current PE ratio of the company.
Trailing PE Ratio
Trailing PE Ratio is the most commonly used metrics by investors; wherein past earnings of a company over a period is considered. It provides a more accurate and objective view of a company’s performance.
Importance of PE ratio
1. Higher the PE ratio, more expensive the stock and lower the PE ratio, cheaper is the stock.
2. The PE ratio is useful in comparing 2 or more stocks. It helps you in identifying which stock is less expensive or highly expensive.
3. Generally, the investor believes that if the PE ratio is high it is overvalued, and if the PE ratio is low it is undervalued.
4. PE ratio denotes how much the company earns today
5. And at what rate does it grows its earnings
6. It is used in the fundamental analysis of a stock.
Limitations of PE ratio
1. Interpretation of PE ratio is heavily dependent on the comparison of the company with its peers.
2. Also, PE that is considered very high in certain sectors can be considered very low in other sectors. For instance, companies in the IT and telecom sectors have a higher PE ratio than the companies in the manufacturing or textile sectors.
3. The PE ratio is not totally neutral. Any major announcement of a major order or acquisition by the company will certainly push up its PE.
4. Low PE may not indicate a good buy but could signify more serious issues facing the company.
5. PE ratio cannot be considered to be a totally reliable indicator of cheap, good stocks.
In the Indian stock market, depending upon the attractiveness of business PE multiple has given.
What If, a business has the below attributes it trades at high PE?
- Market Leader in Industry
- Secular business in nature
- High ROCE
- High ROE
- dividend Payout
- Good Corporate Governance
Example: Nestle India, Asian Paints, HDFC Bank and so many
A business has the below attributes it trades at low PE?
- Cyclical in Nature
- Low ROCE
- Low ROE
- No Dividend Payout
- Bad corporate Governance
Example: Yes Bank, Manpasand Industries, PC jewelers
Warren buffet Views on price-to-earnings (PE) ratio
Warren Buffett’s best-rated book The Intelligent Investor by Benjamin Graham considers that
A PE below 10 is considered low
Between 10 and 20 is considered moderate and
Above 20 is considered expensive
Conclusion
The price-to-earnings (PE) ratio helps in comparing the price of a company’s stock to the earnings the company generates. This comparison helps you understand whether the stock is overvalued or undervalued. Basically, the market price of a stock tells you how much people are willing to pay for the stock but the PE ratio accurately indicates the company’s earnings potential.
Things to Remember
- Generally a high PE ratio means that investors are anticipating higher growth in the future.
- The average market PE ratio is 20-25 times earnings.
- The PE ratio can use estimated earnings to get the forward looking PE ratio.
- Companies that are losing money do not have a PE ratio.
Why beta value is so important in the fundamental analysis of the stock? Please read the fundamental analysis with infographics.
Frequently asked questions
Ans: Generally range of 13 to 15 consider the good PE ratio of the stock. But the stock companies which are Market Leader in Industry, Secular businesses in nature, High ROCE, High ROE, dividend Payout, Good Corporate Governance. These companies have a high PE ratio and it is good for future investments.
Ans: A PE ratio of 30 is considered to be very high as per stock market standards. But again market leader companies have a PE ratio of more than 3
Ans: Of course He uses the PE ratio in terms of future investments. A high PE ratio means that investors are anticipating higher growth in the future.
Ans: A negative PE ratio means a stock company losing its ground. Bad PE denotes negative energy in the stock company.
