Price to Earnings Ratio (PE Ratio) – Meaning, Types, Working
There are several metrics and indicators available for investors that will help them in gauging whether an asset is worth investing in or not. Price to earnings ratio is one such indicator that investors use to understand a company’s health and its future outlook.
It is the ratio of a company’s share price to earnings per share. The main purpose of using this metric is to understand whether a stock is overvalued or undervalued. In this article, we will be discussing this topic in great detail.
What Is PE Ratio?
PE ratio is a metric which makes a comparison between a company’s current share price and earnings per share. It is one of the most standard or basic metrics used for calculating a stock’s intrinsic value.
It may sound like a technical tool. But in reality, it functions as a comparison between the stock’s market price and the actual performance of the same, which is denoted by its earnings per share. Different analysts and investors use this metric to compute the relative valuation of a company’s stock.
A higher price-to-earnings ratio indicates overvaluation of that particular stock. It also tells us that investors have very high expectations from these shares. On the other hand, a company which does not have any earnings or is suffering losses will not have a PE ratio. Now that you are completely aware of the meaning of the PE ratio, let’s shift our focus to other core aspects of this concept.
What Are the Types of PE Ratios?
Here are the different types of PE ratios:
- Forward PE ratio
To calculate this type of price-to-earnings ratio, you need to divide the current market price of a company’s shares by estimated earnings per share over the coming 4 quarters. It is a complex task as it involves forecasting skills. You need to predict future sales, net profits, margins, etc.; additionally, you need to carry out your independent studies and also take help from concerned management for computing the forward price-to-earnings ratio.
- Trailing 12-month PE ratio
To calculate this ratio, the current market share price of the company gets divided by earnings per share of the last 4 quarters. It is quite easy to compute compared to the forward PE ratio as this doesn’t require you to forecast anything; you can determine this ratio on the basis of actual data sets.
The forward price-to-earnings ratio is more relevant than the trailing ratio, as future datasets will provide a better idea regarding future stock prices. However, time series analysis under the trailing 12-months method helps you to assess whether a particular stock or benchmark is overvalued or undervalued when compared to previous PE ratios.
What Are Absolute and Relative PE?
First, let’s consider the absolute PE ratio. Every PE ratio that you come across using the methods mentioned above comes under the absolute PE category. This ratio is what you normally hear or watch in newspapers or television that indicates a company’s performance.
However, the absolute ratio suffers from some limitations as well. The biggest limitation of this is that stocks of different industrial sectors have diverse trading or valuation ranges.
Like, the PE ratio of natural gas and oil companies will always remain lower than the PE ratio of a fast-moving consumer goods company. It may give a false indication that natural gas companies have low prices and are more attractive. This is where a relative PE ratio comes in handy.
A relative PE ratio is a comparison-based metric. It compares the current absolute PE ratio of a company/benchmark with different absolute PE ratios of the past over a specific time period. Usually, it makes a comparison between the present PE ratio and highest PE ratio of the past time period. Suppose the highest PE ratio of the last 15 years stands at 25 and current PE ratio is at 20; it means that relative PE will come out to 0.75.
Hence, the relative PE ratio provides a better idea of how consistently the company or index has performed during a specific time period.
Price to earnings ratio is one of the most effective metrics that you can use to assess investment feasibility of a stock. It helps you understand whether there is overvaluation or undervaluation in a particular stock. If you are looking to invest in any stock across different timeframes, it is important to consider this metric.
Frequently Asked Questions
What is a good PE ratio?
It is a subjective question, and a good PE ratio will be different for every investor according to their considerations. A high PE indicates an overvalued stock, and some investors might not have any issue with investing in such stocks. Nevertheless, as per historical data, PE anywhere between 20 and 25 is considered good.
Is PE ratio the most important ratio to assess a stock’s performance?
Although the PE ratio is a great indicator of the intrinsic value of a stock, as an investor, you should also assess other indicators and ratios to check whether a stock is undervalued or overvalued.
Is negative PE good or bad?
No, a negative PE ratio for a company is not considered to be good at all. This shows that the company is overburdened with debt. A consistent negative ratio means a high chance of the company going insolvent or bankrupt soon.
Can a company’s PE ratio be zero?
Yes, if a company’s earnings are nil for the period, the PE ratio will be ‘0’ or ‘N/A’. It usually happens when a company is reporting a net loss.