Price to earnings (PE) ratio simply describes the relationship between the current market price and the earnings per share (EPS) of the stock.
You will get a stock’s current Price to earnings ratio by dividing the price by the current earnings per share.
PE ratio is also popularly known as earnings multiple.
Here is the mathematical formula to calculate PE ratio;
Price to Earnings ratio = Current market price of the stock / Current earnings per share of the stock
Earnings per share is calculated by taking twelve months net profit divided by weighted average shares outstanding.
For instance, if the market value of the share is Rs 200 and annual net profits per share is Rs 2, the Price to earnings ratio for the company is Rs 100 (Rs 200 divided by Rs 2).
PE ratio tells the investor how much the market is willing to pay for one rupee of profits.
In our above example, investors are paying 100 times the company’s EPS. This means for each one rupee of profit investors are willing to pay 100 times to buy one share of the company.
Price to Earnings Ratios: Separating the Winners and Losers
Current PE ratio of a stock is considered as the most common measurement to know how cheap or expensive it is relative to other stocks.
High price to earnings (PE) ratio indicates that more investors are paying for earnings with an expectation for future earnings growth.
Low PE ratios indicate lower investor expectations for earnings growth.
P/E ratio will help you to determine the future market value of the stock based on the company’s future estimated profits.
This means, if you can predict companies’ future profits based on different growth parameters, the future stock value can easily be predicted. In this way, the market’s expectations can be predicted.
Price to earnings ratio or earnings multiple increases when share value moves higher.
A high earnings multiple indicates that the investors have high expectations for future profits and are willing to pay more in future with growth in profit. However, investing in a high PE multiple stock can be risky in a volatile market. Low earnings multiple indicates that the market has till date undervalued the stock.
Price to earnings ratio can also tell you whether a particular share is available cheaper or not.
For instance, if shares of company A are trading at Rs150 and Company B is at Rs 200, you can not say that company B is costly in comparison to company A by just looking at its current market value. You need to first check both company’s profits and then its PE multiples. If company B has lower PE multiples but expected to have a good growth in profit then it can be a better choice than company A. You can also consider the industry average PE ratio to get more clarity.
Price to earnings ratio varies from industry to industry and therefore, while comparing you should consider companies from the same industry and size.
Also Read: How to know whether a stock is undervalued or overvalued based on PE ratio
When investors bet for Low Price to earnings ratio stocks
Many market participants look for low price to earnings ratio stocks.
These investors think that they are getting a bargain. Generally they believe that the prices of low PE stocks are at a discount and when earnings of the company recover, the price of the stock will follow.
Should you completely avoid High PE stocks
Many market participants think that buying high PE stocks regardless of their market capitalisation is a dangerous endeavor. These investors believe that the market has unrealistic earnings growth expectations on high PE stocks. When expectations don’t meet, the price will fall.
However, if the company’s growth story is intact, then investors keep buying the stock even with a high PE ratio. We have many such stocks which are trading at a high PE ratio.
Companies with a high PE ratio are generally considered as better for investment, but it’s not always advisable to invest based on earnings multiple. A company with a low price to earnings ratio can be a better choice than a company with a high earnings multiple if the former is expected to generate higher growth in profits than the latter.
You can’t always rely on price to earnings ratio as a yardstick of your investment decision. We suggest you dig deeper into the company’s financial statements to find a better picture of the company.
