Understanding price earning or PE ratio

PE ratio which is also known as price earnings ratio, is the most popular indicator used by investors for stock election.

Price earnings or PE ratio is calculated by dividing company’s market price of the stock by its earning per share or EPS. It tells you the value that market thinks a company deserves to its net profit or what the market is willing to pay for the company’s earnings.

Price to Earning Ratio determines whether share price of a company is fairly valued, under valued or overvalued. Stocks with high PE ratio can be considered as priced much higher than its actual growth potential and suggest us that investors are expecting higher earnings growth in future.

Companies with low PE can be considered as a good bargain. Price earnings ratio can be compared for two or more companies from the same industry.

Mathematical formula of PE ratio = Current Market price per share / earning per share

Understanding PE ratio – Price earnings ratioBoth earnings per share and current market price can be obtained from the stock market like BSE or NSE.

If you are trying to find out PE of a NASDAQ or NYSE listed company then you have to get these values from there.

Market price of a stock or share is the price at which the stock is currently traded on the stock market where as earning per share is calculated by dividing the company’s net profit by its number of share outstanding.

Also read: How to calculate EPS of a company

PE ratio can not considered to be totally reliable for decision making. While taking decisions we need to take into account several other factors in addition to PE.

What is Forward PE

For investing into share market, investors use to project the future PE ratio of a company based on its expected earnings and expected EPS. Price earnings calculated based on these expected EPS and profit is called forward PE ratio.

If forward PE is higher than the current PE then share is undervalued and is good to invest. Similarly, if forward PE ratio is lower than current PE ratio then shares are overvalued and are required to be sold.

Example:

Company X ltd’s current market price per share is Rs. 40 and EPS for the same period is Rs. 2.

Current PE ratio = Current Market price per share / Earning per share = 40/2 = 20

PE ratio of 20 indicates that investors are willing to pay 20 times for every rupee of company’s earnings.

You can get PE ratio of all listed companies from a financial newspaper or magazine which updates these figures regularly.

PE ratio is the only number which analysts look at than any other number or ratio. Your investment should be based on the willingness to pay for earnings. If you think that the company will have higher profits in future then you will be willing to pay more for its earnings by which the company will have higher PE ratio.

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