The price-to-earnings (PE) ratio is among the popular tools for evaluating a stock’s value. It is commonly used by investors, analysts, and fund managers for a variety of functions such as comparing companies, tracking industry trends, and more. For beginners getting into investing, it is one of the basic ratios to know. Hence, here we provide an easy-to-understand guide to learning PE ratio. Scroll down to learn.
Understanding the PE ratio
PE ratio It is the short form of price-earnings ratio. It is the ratio of the value of a company’s shares to the amount paid for each dollar of profits. Simply put, the PE ratio is the ratio of a stock’s price to its earnings per share (EPS). It tells you how much the market is willing to pay for each unit of profit the company makes.
PE ratio for beginners in investing
The PE ratio is a quick way to measure how cheap or expensive a stock is compared to its earnings. Let us understand this with an example. If a company’s stock is trading at INR 240 per share and its EPS is INR 20, then,
P/E ratio = 240/20
P/E ratio = 12
The result will be interpreted as investors currently paying INR 12 for every INR 1 in profit the company earns.
Uses: It helps determine whether investors expect the company to grow quickly or are evaluating it more cautiously.
Note: However, remember that PE ratios vary widely across industries. This means that a fast-growing technology company may have a high PE ratio because investors expect future earnings to rise quickly. In contrast, a company based in the manufacturing or utilities sector may have a lower P/E ratio.
This is because its profits are stable, but growth prospects are not high. Understanding this difference helps new investors avoid the mistake of comparing PE ratios across unrelated industries.
Formula for PE ratio
| P/E ratio = Market price per share / Earnings per share (EPS) |
Market price per share: It indicates the current value of one share in the stock market
EPS: It indicates the amount of profit achieved by the company per share during a specific period. This period is generally a fiscal year.
Furthermore, earnings per share are calculated using the formula:
| EPS = (Net Income – Dividends on Preferred Stock)/Average Shares Outstanding |
Interpretation of PE ratio
The value of the PE ratio may be high or low depending on the industry. It will be interpreted as follows:
- A higher PE ratio usually reflects positive probabilities about future earnings
- A lower ratio may indicate limited growth prospects or a depreciation of the currency.
The role of PE ratio in investing
PE ratio finds the following importance in investment:
It helps to compare stocks easily
The PE ratio allows investors to evaluate the relative value of a stock. A low PE ratio may indicate that the stock is undervalued. In contrast, a rise indicates an overvaluation or strong growth outlook.
Helps in comparing industry standards
Each industry operates with its own standard for acceptable PE ratios. For example:
- Technology or pharmaceutical companies often show higher ratios due to innovation and expected growth.
- The manufacturing or utilities sector tends to achieve moderate to low ratios due to steady but slower expansion.
This ratio is misleading for comparing companies from different industries. However, it helps to identify unusual variation patterns and make informed decisions in a particular sector.
Helps understand growth versus value investing
The PE ratio helps differentiate between growth and value investment opportunities. Growth-oriented investors often choose companies with high PE ratios because they expect high future earnings. Value investors, on the other hand, focus on low-end private equity stocks that may be temporarily undervalued but are financially worth the pick.
Tracks market sentiment and confidence
Fluctuations in the PE ratio often reflect broader market sentiment. It is used by investors to determine potential risks and returns.
Supports financial analysis
Experienced investors do not rely on the PE ratio alone. It is used with other financial indicators such as:
- PEG ratio that adjusts to growth rate
- Debt to equity ratio
- Cash flow analysis
Full details indicate the company’s financial condition and long-term potential.
Types of PE ratio
PE ratios can be calculated in different ways depending on whether they use past, current or forecast earnings. Here’s an insight into their different types:
Trailing PE ratio
It is also known as the trailing twelve month (TTM) P/E ratio. It is calculated by dividing a stock’s current market price by its total earnings per share (EPS) over the last four quarters.
Uses: TTM PE is generally used to evaluate companies with a consistent earnings history or to compare a stock’s current valuation to its previous average.
Forward PE Ratio
The forward PE ratio uses expected earnings rather than past data. It is obtained by dividing the current market price of a stock by the estimated earnings per share for the next four quarters.
Uses: Forward PE is useful in analyzing growth-oriented companies where future performance is important. It includes the technology and renewable energy sectors.
Absolute PE ratio
This ratio is obtained using trailing or forward earnings. It directly indicates how expensive or cheap a stock is based on its earnings. However, it can be misleading when comparing companies in different industries.
Uses: Hence, the absolute PE ratio is most appropriate for comparing companies within the same sector.
Relative PE ratio
It compares a company’s current stock price with its previous stock price range, generally over a period of the past 5 to 10 years.
Uses: It helps investors evaluate whether a stock is trading above or below its usual valuation range. This helps identify valuation trends and judge whether a stock is undervalued or overvalued.
summary
The P/E ratio is a practical and useful tool for evaluating a stock’s valuation. It helps to understand how the market perceives a company’s growth potential. Moreover, the ratio helps in making informed investment decisions by comparing stocks, assessing market sentiment and identifying growth opportunities. The different types of PE ratios also allow for evaluation of both current and future performance Expectations.
