EN
Ever wondered how experienced investors anticipates the company’s value or identify a multi-bagger stock? There are multiple parameters that help them taking an informed decision for investment. One of the major criteria that they look at before investing in a particular stock is the P/E ratio of the company. Now, let’s define the P/E ratio in the simplest terms possible.
Key Takeaways
-
The P/E ratio is calculated by dividing a company’s current share price by its earnings per share (EPS), providing insight into how much investors are willing to pay for each rupee/dollar of earnings.
-
A low P/E may signal that a stock is undervalued relative to its earnings, while a high P/E could indicate overvaluation or high growth expectations.
-
There are two types of P/E: trailing P/E (based on the past 12 months of earnings) and forward P/E (based on projected earnings), each offering different insights.
-
P/E ratios are most meaningful when compared within the same industry or sector, or against a company’s own historical P/E, rather than being used in isolation.
What is the PE Ratio?
In India, the price-to-earnings (P/E) ratio is a popular metric used to assess a stock’s valuation or the broader market. Here, the P stands for “Current Market Price (CMP) of a single share”, and E stands for “Earnings Per Share (EPS).” The P/E ratio helps understand the company’s worth today and the growth anticipated based on how its share prices are relative to its earnings per share.
What is a PE Calculator with an Example?
Suppose a company has an EPS of ₹10, and the CMP of its share is ₹100. So, the P/E ratio is 10. This means that an investor is willing to pay ₹10 for ₹1 of the company’s earnings.
If a P/E ratio is high, investors deduce that the stock is overvalued and sell the shares or refrain from buying. In case the shares are undervalued, investors purchase them at lower rates to claim profits when the unrealised value is tapped. There is no ideal P/E as such, but as per historical data, an acceptable P/E value ranges between 20-25.
Remember that a high P/E stock can always gain momentum in the market. However, a question that is often asked is, “How high is better”? The answers depend more on the investors. A P/E will never be high if more people are not thinking about these stocks. This is one of the main reasons why some stocks are overvalued or sold at a premium. That’s why it’s important to also look at the management before investing for good returns.
What is the PE Ratio Formula
The P/E ratio formula is used to compare a company’s share price to its earnings per share. Calculating the ratio also helps answer one of the most asked questions: Is the stock worth the price? Once you have the P/E ratio, you can determine whether the stock is overvalued, undervalued or fairly valued based on the company’s current earnings and industry P/E ratio.
The P/E ratio formula is:
P/E Ratio = Price per Share / Earnings per Share
Where,
-
Price per share is the current market price of a single share of the company.
-
Earnings per share represent the company’s total earnings divided by the number of outstanding shares.
Types of P/E Ratio
-
Absolute P/E ratio: The absolute P/E ratio in the stock market is calculated by dividing the current market price of a stock by its earnings per share (EPS) for the most recent 12-month period. This ratio indicates how much investors are willing to pay for each unit of earnings generated by the company. Generally, a higher absolute P/E ratio indicates that investors are willing to pay a premium for the stock’s earnings, while a lower P/E ratio suggests that the stock may be undervalued.
-
Relative P/E ratio: The relative P/E ratio, also known as the P/E ratio compared to the market or sector average, is calculated by dividing the absolute P/E ratio of a stock by the average P/E ratio of its peer group or the broader market. This ratio indicates whether a stock is overvalued or undervalued compared to its peers or the overall market. A relative P/E ratio above 1 indicates that the stock is trading at a premium compared to its peers or the market, while a ratio below 1 suggests that the stock is undervalued.
-
Trailing price-to-earnings: The trailing P/E depends on the past performance of a company. It is calculated by dividing the recent stock price by the total EPS earnings over the past year. It is one of the most reliable and popular PE metrics, using actual data on the company’s profits. Prudent investors take the trailing P/E as the basis of most of their financial decisions, as future earnings estimates could be unreliable. However, investors must remember that a company’s past performance does not necessarily guarantee its future behaviour.
-
Forward price-to-earnings: The forward (or driving) P/E utilises estimated future income as opposed to trailing earnings figures. It is also known as the estimated cost of earnings. This indicator is valuable for providing a base of comparison between the current income and future income. It gives a clearer image of what and how the company’s profits will pan out.
What Is a Good Price-to-Earnings (P/E) Ratio?
While investing, many investors question: What is the best P/E ratio of a stock? Well, the answer depends on the industry. It is crucial to understand that whether a P/E ratio is good or bad depends on the current market conditions, the industry average of the P/E ratio in the stock market and the nature of the industry.
While a high P/E ratio could indicate solid growth potential, it is associated with risk; a lower P/E ratio might seem attractive to some investors, but it may also mean weak performance by the company and could indicate higher risks.
That said, while there is no single good or bad P/E ratio in the stock market, a P/E ratio between 20 and 25 is often considered reasonable and a good benchmark.
Relationship Between P/E Ratio and Value Investing
The price-to-earnings (P/E) ratio is an essential metric in value investing, which is an investment strategy that involves buying stocks that are undervalued by the market. Value investors believe that the market can sometimes misprice stocks and that by identifying companies with strong fundamentals trading at a discount to their intrinsic value, they can generate superior returns.
The P/E ratio in the stock market is used by value investors as a tool to assess whether a stock is overvalued or undervalued by the market. Stocks with a low P/E ratio relative to their peers or the broader market may be considered undervalued and potentially good investment opportunities. This is because a low P/E ratio in the stock market suggests that the market is not fully valuing the company’s earnings potential and that the stock may be trading at a discount to its intrinsic value.
Using PE Ratios To Determine Investment Strategies
PE ratios help in share selection. A low trailing P/E of a promising company’s stock could be an excellent investment. A high P/E usually indicates that the price is overvalued compared to the company’s earnings.
However, if the economy is booming, a high ratio does not mean the shares are overpriced, as the overall market sentiment is positive. So, while P/E ratios are used to select stocks, careful estimation and relative assessment of the total ratio reap profits in the long run.
Also, some companies have a Negative P/E ratio, which happens when a company has negative earnings or loses money. If a company’s earnings per share are lower than zero, then the stock can have a negative P/E ratio. Any company (big/small) can have a negative P/E ratio. However, if any company has a consistent negative P/E ratio, then it is not generating enough money.
Sector-wise PE Ratios
PE ratios could vary from industry to industry. A possible way of determining if a sector or industry is overpriced is when the average P/E ratio of all the organisations in that sector or industry is much more than the historical P/E average.
While investing, investors gauge the market value of the industry, in general, to understand how a sector is faring and then compare it to the individual company’s stock price to make a calculated judgment.
Limitations of Price Earnings (PE) Ratio
-
Industry variability: Different industries have different PE norms. A high PE in one industry might be normal, while the same PE might be considered high in another industry where lower ratios are typical.
-
Lack of context: PE doesn't consider external factors like economic conditions, competition, management quality, and industry trends. It's just one piece of the puzzle.
-
Volatility: Stock prices and earnings can fluctuate, making PE ratios inconsistent. A temporary earnings dip or surge can distort the ratio.
Conclusion
The P/E ratio is an essential tool to understand the company and market behaviour at any given point in time. Investors and companies rely on this ratio to make financial decisions and effectively value their stocks based on the share market value and earnings to date or future earnings. PE ratio, though a comprehensive metric to evaluate a specific company’s worth, can be inconsistent at times due to fluctuating stock prices or earnings.
Now that we know what PE in the stock market is, a well-researched and informed approach should be followed when investing. So, once you are done with your research, take your first step in investing by opening a Demat account.