There are several companies whose shares are traded daily in the stock markets. However, it can be difficult to select one of them by just looking at their current market price. Instead, investors should make use of several indicators to analyse the performance of stocks and take a correct decision.
Price to earnings or PE ratio is one indicator that allows investors to understand a stock’s intrinsic value. It is the ratio of the current market price of the respective stock to its earnings per share. Let’s see how you can use it for investment purposes.
What Is the PE Ratio?
The Price to earnings ratio is a popular indicator to evaluate if the share price of the company is valued properly relative to its earnings. The current trading price of a stock is indicative of how much investors are willing to shell out to purchase one unit. In this regard, the price-to-earnings ratio helps to identify the earnings potential of the company or its valuation accurately.
Let’s understand the meaning of the PE ratio with an example. Suppose the current share price of ABC Limited is ₹80, and earnings from one share stand at ₹5. Then, the PE ratio will come out as 16. In other words, we can conclude that it will take around 16 years for the company’s profits to cover the investment cost.
Apart from stocks, you can also compute the PE ratio for various indices. As the market price of benchmark indices and the company’s shares keep on changing, this ratio also undergoes changes from time to time. Moreover, changes in the company’s earnings every quarter also change the PE ratio.
What Is the Formula to Calculate PE Ratio?
The Price to earnings ratio formula is as follows:
PE Ratio = Market price of the share/ Earnings per share (EPS)
In order to compute earnings per share, you need to divide the respective company’s net profits by its outstanding number of common shares.
It is very easy to compute this ratio as the information related to the current share price and earnings per share is readily available on the company’s website/exchanges.
What Are the Various Types of PE Ratios?
Here are the various types of PE ratios that you should know about:
- Forward earnings
In this type of price-to-earnings ratio, investors use the expected future earnings of a company to analyse its share price. You can compute this ratio by dividing the current market price of the company’s stock by its expected earnings per share over the next four quarters.
It is a complicated process as it entails forecasting sales, profit margins, and earnings per share. Participants derive this ratio using rigorous research using available information.
- Trailing twelve-month earnings
Also known as TTM earnings, it uses the value of a company’s profits over the last 12 months to determine the PE ratio. One of the main advantages of this ratio is that you are using actual reported data. Therefore, it is easier to compute and is more reliable.
- Shriller PE ratio
Under this type of PE ratio, you shall be using the weighted average earnings of the company over a certain time period. It is also referred to as a cyclically adjusted price-to-earnings ratio. You need to divide the current market price of the company’s stock by the average earnings of the company over a 10-year period after adjusting them for inflation.
We can see that there are several ways to determine the price-to-earnings ratio. Some methods involve finding out future trajectories by forecasting, while some involve using past-reported data. All have their own usefulness, and their applicability varies from one industry to another.
What Does a High or Low PE Ratio Indicate?
As it represents a numerical value, PE ratios will either be in a higher or lower band depending on the company’s fundamentals. Stocks in different sectors trade in different valuation (PE) ranges
A company having a high PE ratio represents a growth-oriented stock that may see an exponential rise in its value in the future. A high P/E could mean that a stock’s price is high relative to earnings and possibly overvalued.
Conversely, a low P/E might indicate that the current stock price is low relative to earnings and are known as value stocks.
Conversely, a low P/E might indicate that the current stock price is low relative to earnings and are known as value stocks. This means that their shares are trading at a lower value with regard to their fundamentals. As a result, investors are optimistic that markets will correct themselves and share prices will rise to appropriate levels. These are generally found in mature sectors that come with a stable rate of dividends.
Also Read: Delta Hedging: Meaning, Example, Pros & Cons
What Are the Advantages of PE Ratio?
Some advantages of the PE ratio are as follows:
- It helps in comparing the performance of stocks of various companies.
- One can get an idea about the accurate valuation of a company’s share price. Hence, this metric is useful in ascertaining whether a stock is undervalued or overvalued.
- This ratio helps in tracking a company’s growth performance over a period of time. By looking at its past performance, investors can get an idea about the future outlook and take appropriate decisions accordingly.
- The price-to-earnings ratio is quite useful in analysing companies operating in the same sector.
What Are the Disadvantages of PE Ratio?
Some disadvantages of using price-to-earnings ratio are as follows:
- These ratios may not be useful for growth stocks. You may be comfortable investing in companies with higher PE , if you know companies growth in EPS will bring PE ratio down to lower level..
- Another major drawback of using this ratio is that it does not consider the debt situation of the company. Therefore, it may not be able to provide any indication of its stability.
- Companies may use different accounting policies, and this plays a major role in undermining the comparison of their PE ratios.
The PE ratio is quite a useful indicator when traders want to know the valuation of a company’s stock. They can use forecasts of future variables or past actual reported data to calculate this ratio. However, it is imperative for investors to consider other indicators as well while making any investment decisions.
Frequently Asked Questions
What can be a good PE ratio?
There can be different valuation ranges for a particular stock. The growth stocks come with a higher ratio as compared to their value counterparts. A good price-to-earnings ratio is subjective and may vary from one sector to another.
You can look at historical PE values and finalise higher and lower bands of the same. After that, compute the current PE ratio, and see whether it is near the higher or lower band. If this ratio is near the lower range, it represents a good investment opportunity subject to other factors.
What is the difference between absolute and relative PE?
Absolute PE ratios are derived using the forward or trailing 12 months method. On the other hand, a relative PE ratio is calculated by comparing the absolute value with a series of historical price-to-equity ratios over a set time period.
What is the limitation of absolute PE?
A big limitation of the PE ratio is that the share prices of companies operating in different sectors can have diverse valuation ranges, so it can be misleading at times. The PE of an automobile company may be lower than that of an FMCG company; however, it does not mean that the share price of the former is lower than the latter.
What is the difference between PE and PB ratios?
Price to book or PB ratio represents the relationship between a company’s market value and its corresponding book value. On the other hand, the PE ratio exhibits the relationship between the company’s earnings and its stock price.
Krishna is an investment professional with a demonstrated history of working in Debt Capital Markets. He has completed his B.E. (Hons) in Computer Science Engineering from BITS Pilani and MBA (Finance) from JBIMS, Mumbai. He is currently working as Investments Principal at Wint Wealth. Previously he worked at Kotak Mahindra Bank at their DCM desk and Northern Arc Capital at their Structured Finance desk.