The Price To Earnings ratio ( P/E Ratio ) is the ratio used to value a company, measuring its current share price relative to its earnings per share (EPS). The price-earnings ratio is sometimes also referred to as the price multiple or the earnings multiple.
The price to earnings ratio is used by investors and analysts to determine the relative value of a company’s stock in an apples-to-apples comparison. It can also be used to compare a company to its own historical data or to compare aggregate markets to each other or over time.
The P/E ratio can be estimated both retrospectively and prospectively.
Highlights
- The price to earnings ratio (P/E ratio) relates a company’s share price to its earnings per share.
- A high P/E ratio can mean that a company’s stock is overvalued or that investors expect high growth rates in the future.
- Companies that are not earning profits or are making losses do not have a P/E ratio because there is nothing to put in the denominator.
- In practice, two types of P/E ratios are used -the forward P/E ratio and the trailing P/E ratio.
Content Outline
How Does the Price to Earnings Ratio ( PE Ratio ) Work?
The P/E ratio helps investors measure the market value of a stock compared to the company’s earnings. Simply put, it tells them how much the market is willing to pay for a stock based on the company’s past and future earnings.
For example, a high P/E ratio tells you that the stock price is high compared to the company’s earnings and may be overvalued. Similarly, a low P/E ratio indicates that the stock price is low compared to company earnings and is undervalued. However, you need to determine if the reason for the low stock price is the company’s underperformance over a period of time.
Earnings are important in valuing a company’s stock because investors want to know how profitable a company is and how valuable it will be in the future. Furthermore, if the company’s growth and level of earnings remain constant, the P/E ratio can be interpreted as the number of years it will take the company to pay back the amount paid for the stock. Investors often look at this ratio because it gives them a good sense of the company’s value and helps them analyze how much they should pay for a stock based on current earnings.
In addition, if the company’s growth and level of earnings remain constant, the P/E ratio can be interpreted as the number of years it will take the company to pay back the amount paid for the stock. Investors often look at this ratio because it gives them a good sense of the company’s value and helps them analyze how much they should pay for a stock based on current earnings.
Price to Earnings Ratio ( P/E Ratio ) Formula
P/E Ratio = Current Market Price of a Share / Earning Per Share
what is EPS?
Earnings per share (EPS) is a company’s net income divided by the number of shares outstanding.
The price-earnings ratio (P/E ratio) is one of the most commonly used ratios by analysts and investors around the world. It indicates how much money an investor is willing to invest in a single share of a company for Re. 1 of its earnings.
For example, if a company has a P/E ratio of 20, investors are willing to invest Rs. 20 in its shares for Re. 1 of their current earnings. Thus, if a company has a high P/E ratio, it means that the company is either overvalued or on a growth path.
Another interpretation of a high P/E ratio could be that such a company is expected to have rising earnings in the future and the corresponding speculation by analysts and investors has led to a jump in current share prices.
On the other hand, a low P/E ratio indicates that shares are undervalued due to systematic or unsystematic risk in the market.
A low price-earnings ratio could also mean that a company will perform poorly in the future, which is why its share prices are falling at the present.
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Types of P/E Ratio
There are mainly two types of P/E ratios that investors consider – the Forward P/E ratio and the Trailing P/E ratio. These two types of P/E ratios depend on the type of earnings, as enumerated below.
Forward P/E Ratio
- It is calculated by dividing the prices of a single unit of stock of a company and the estimated earnings of a company based on its future earnings forecasts. Since such a ratio is based on a company’s future earnings, it is also called an estimated P/E ratio.
- Investors use the Forward Price to Earnings Ratio to assess how a company is expected to perform in the future and what its expected growth rate will be.
Trailing P/E ratio
- The trailing price-to-earnings ( P/E) ratio is the metric most commonly used by investors that takes into account a company’s past earnings over a period of time. It provides a more accurate and objective view of a company’s performance.
Relationship Between P/E Ratio and Value Investing
Investors who apply the principles of “value investing” in their stock market transactions take into account the intrinsic value of a company’s underlying assets rather than the current market price.
The price-earnings ratio (P/E ratio) is one of the most important metrics used in this regard, as it helps determine whether a stock is overvalued or undervalued.
If a company has a high P/E ratio, it means that the company’s stock prices are relatively higher than its earnings and therefore may be overvalued. Value investors stay away from trading such overvalued stocks, as this indicates high speculation and makes the company vulnerable to systematic risks resulting from inefficient fund management. This approach allows investors to avoid a value trap.
On the other hand, if a stock’s P/E ratio is below average, this means that stock prices are too low relative to the company’s earnings and are therefore undervalued. Value investors view this scenario as a positive indicator for investments, as they can buy these shares at a lower price compared to their intrinsic value and later sell them at a higher amount when these share prices rise.
Value investing requires holding stocks for the long term so that investors can take full advantage of their benefits. It is also important to consider the average P/E ratio of the industry to which a particular company belongs before deciding whether the stock is overvalued or undervalued.
Absolute Price to Earnings Ratio & Relative Price to Earnings Ratio
There are two other types of P/E ratios that help determine a company’s performance.
Absolute P/E ratio
- It refers to the traditional P/E ratio, where a company’s current stock price is divided by either past earnings or future earnings.
Relative P/E ratio
- When calculating relative P/E ratios, a company’s absolute ratio is compared to a benchmark P/E ratio or the past price-to-earnings ratio of the respective companies.
It is used by investors to determine how well a company is performing compared to its past ratios or its benchmark ratios. For example, if a company’s relative P/E ratio is 90% when compared to a benchmark P/E ratio, it means that the company’s absolute ratio is lower than that of the benchmark. Conversely, a P/E ratio of more than 100% means that a company has outperformed the benchmark index over the specified period.
What is a Good P/E ratio?
One question that puzzles investors when using the P/E ratio to decide where to invest is what can be considered a good or safe ratio. However, it is important to know that the goodness of a ratio depends on current market conditions, the industry average of P/E ratios, the type of industry, etc.
So when investors evaluate different P/E ratios, they should consider how other companies in the same industry with similar characteristics and in the same growth phase are performing.
For example, if Company A has a P/E ratio of 40% and Company B with similar characteristics in the same industry has a ratio of 10%, it essentially means that Company A shareholders will have to pay Rs. 40 for Re. 1 of their earnings and Company B shareholders will have to pay Rs. 10 for Re. 1 of their earnings. Therefore, in this case, an investment in Company B might be more profitable.
While high ratios are associated with the risk of a value trap, lower ratios may indicate that a company is underperforming due to internal errors.
Thus, there is no foolproof P/E ratio that investors can rely on when investing in the stock market. In this context, other indicators of technical analysis such as discounted cash flow, the weighted average cost of capital, etc. can be used to determine the potential profitability of a company.
Limitations of the P/E ratio
Although P/E ratio analysis provides a fair assessment of whether a company’s stock is overvalued or undervalued, it is still prone to error.
The P/E ratio calculation does not take into account the growth rate of a company’s earnings per share. Therefore, investors also use the PEG ratio or the earnings to growth ratio to decide which company is more promising.
Another reason why the Price to Earnings Ratio cannot be used alone to make an investment decision is that a company’s earnings are released quarterly, while stock prices fluctuate every day. Therefore, the P/E ratio may not match a company’s performance for a long time, leaving investors enough room for error.
Therefore, investors should never decide whether a company is worth investing in based on its Price to Earnings ratio alone. They should also consider a number of other factors that have a major impact on the true value of stocks. These include whether the company’s industry is in an economic crisis or experiencing a cyclical upswing, the company’s past results, the size of the company (large-cap, mid-cap or small-cap), EPS growth prospects, the industry to which the company belongs, the average P/E ratio in the stock market, the performance of companies of similar size, current and future demand in the industry in question, etc.
