P/E or Price to earnings ratio simply describes the relationship between the market share price and the earnings per share. Its calculated by dividing the current market value of the share by the EPS. P/E ratio is also popularly called an earnings multiple.
Price to Earnings ratio = current share price / Earnings per share
Earnings per share is calculated by taking twelve months net profit divided by weighted average shares outstanding.
For instance, if 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).
P/E ratio tells the investor how much market is willing to pay for one rupee of profits. In our above example, investors are paying 100 times of the EPS, this means for each one rupee of profit investors are willing to pay 100 times.
Price to earnings ratio will help you to determine the future market value of the stock based on company’s future 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, 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 P/E multiple stock can be risky in a volatile market. Low earnings multiple indicates that 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 share of company A is trading at Rs.150 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 P/E multiples. If company B has lower P/E multiples but expected to have a good growth in profit then it can be a better choice than company A. You can also consider industry average P/E 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.
Companies with high P/E ratio is generally considered as better for investment, but it’s not always advisable to invest based on earnings multiple. A company with low price to earnings ratio can be a better choice than a company with high earnings multiple if the former is expected to generate high 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 to dig deeper into the company’s financial statements to find a better picture of the company.