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.
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
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.
What is Forward PE
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.
Company X ltd’s current market price per share is Rs. 40 and EPS for the same period is Rs. 2.
Current Proce-to-Earnings ratio = Current Market price per share / Earning per share = 40/2 = 20
Price-to-Earnings 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, 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.