PE ratio, which is also known as price-to-earnings ratio, is the most popular indicator used by investors for stock election.
Price-to-Earnings or PE ratio is calculated by dividing company’s market price of the stock by its earning per share or EPS. The best part of the P/E ratio is that it establishes a direct relationship between the bottom line of a company’s operations, the earnings and the stock price.
PE ratio 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.
For instance, suppose a company XYZ limited earns Rs 100 per share and its current share price is Rs 400. This gives a P/E ratio of Rs 4. If the average industry P/E ratio is 6, then the share of company XYZ is undervalued. If there is another company ABC limited in the same industry with P/E ratio of 10, the share of company XYZ is overvalued.
Stocks with high Price-to-Earnings 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 Price-to-Earnings (PE) ratio can be considered as a good bargain. Price-to-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
Both earnings per share and current market price can be obtained from the stock exchange like BSE or NSE.
If you are trying to find out PE ratio 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
What high and low PE ratio indicates
If the market price of a single stock is Rs 20 and the earnings are Rs 2, then P/E ratio is 10. When the share price goes up to Rs 40, your P/E ratio changes to 20. Similarly, if the market price comes down to 10 with the same earnings, then P/E ratio is 5.
Basically, the P/E ratio determines the earnings multiple. If it’s high, you pay more to buy the stock. If it’s less you pay less to buy the stock.
Price to earnings ratio increases because investors always invest with expectation of higher profit in future. If they think that a particular company will have higher profit, then they bid for a higher price, resulting in a higher P/E ratio. Remember the reverse is also true.
High P/E ratios are always a warning signal for value investors. If the company does not achieve the expected earnings, then the stock price could fall.
To know the extra premium you are paying,you need to compare a stock’s P/E against the P/E of other companies in the same industry. You can also compare it with the changing PE of the entire stock market.
You will find many stocks trading at a high P/E because they are growing more rapidly than others. For instance, if a company has net earnings of 5 and current market price of 100, then P/E ratio can be calculated as 20. You may find it overvalued if other companies are trading at PE of 15. Does this comparison hold good for taking an investment call? To know why it’s trading at a higher PE, you need to look into the earning growth rate of the company. If the company trading at PE of 20 is expected to grow at 30% in future in comparison to a growth rate of 20% for all other companies in the same industry, then it’s worth investing in a company with PE of 20 as its valuation is good.
To compare a stock’s PE to its expected growth, you calculate PEG. To calculate PEG, you need to divide the stock’s PE by the expected growth rate. You can find out the estimated growth rate from a company’s historical growth rate in earnings and revenue.
Please note, there is no concrete definition of when a P/E is too high. However, you can consider selling when a company’s PE gets high relative to other stocks in the same industry.
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 Price-to-Earnings ratio.
Here are certain standard rules followed for P/E ratio while evaluating stocks;
- Company company’s P/E ratio with its industry
- Compare company’s P/E ratio with the general market
- Low P/E ratios are not necessarily a sign of a bargain.
- Higher P/E ratios are not necessarily bad
Different type of price to earnings ratio
A stock’s price to earnings ratio changes every day along with a stock’s market price.
Current PE – Divide stock’s price by what it’s expected to earn in the current fiscal year.
Trailing PE – divide stock’s price by its net earnings per share over the past 12 months earnings.
Forward PE – divide a stock’s price by what it’s expected to earn in the next fiscal year.
Operating PE – divide stock’s price by company’s operating income.
For investing into share market, investors use to project the future Price-to-Earnings (PE) ratio of a company based on its expected earnings and EPS.
Price-to-Earnings ratio calculated based on these expected EPS and expected profit is called forward PE ratio.
If the forward PE ratio is higher than the current PE ratio, 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.
In contrast, P/E ratio computed using the earnings per share for the year gone by, is called a trailing PE.
You can get PE ratio of all listed companies from a financial newspaper, financial websites 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.
