What is P/E Ratio?
The price-to-earnings ratio is otherwise
known as the P/E ratio and it is used to value a company that measures the current share price that it has relative to its earnings per share (EPS). It is also known as the price multiple or the earnings multiple.
The earnings from various different periods can be considered to calculate this ratio although the variable which is most commonly used is the earnings of the company from the last year.
The P/E ratio formula and Calculation Process
This ratio denotes the amount that an investor would want to invest in one share of the company for Re. 1 of the earnings and it is a metric which is greatly used by investors from all over the world.
The formula is,
P/E ratio = Current market value per share / Earnings per share
For example, if a company has a P/E ratio of 10, INR 10 is the amount that investors are ready to pay in stocks for Re. 1 of the earnings present.
The price-to-earnings ratio assists in knowing the valuation of a stock and understanding whether it is overvalued or undervalued.
When a high P/E ratio is shown, this means the company is on a path of growth or is overvalued. The company may also expect higher revenue in the future due to speculation by analysts which may cause a rise in stock prices.
If the P/E ratio is low, it shows undervaluation of stocks and indicates a systematic or unsystematic risk that may be present in the market. Another interpretation could be that the company is not expected to perform well in the future.
What are the different types of price to earnings ratio?
Investors mainly take two types into consideration and they are,
Forward P/E ratio –
It is also called estimated ratio as it is a forward looking indicator which mainly compares the future earnings with the current earnings available.
The prices of a single unit of a particular stock and the estimated earnings of a company which is derived from its earnings in the future need to be divided to calculate the Forward P/E ratio.
Trailing P/E ratio –
This is a metric which depends on using the past performance by dividing the current share price by the total amount of EPS earnings over the past year or twelve months.
It is accurate and objective while being known as the most popular type of P/E ratio.
A few investors use the trailing P/E because another individual’s estimates when it comes to earnings cannot be easily trusted or taken into consideration.
What is Absolute P/E ratio and Relative P/E ratio?
- The Absolute P/E ratio is the traditional P/E ratio and it can be calculated by dividing the company’s current stock price by the past or future earnings.
- The Relative P/E ratio is computed by comparing the absolute ratio against the previous P/E ratios of companies or a specific benchmark of a P/E ratio which had been set.
An instance can be taken where if the relative P/E ratio of a company is 80% when compared with the benchmark ratio set, this goes to state that the company’s absolute ratio is below the benchmark.
If the relative P/E ratio is above 100% for a company in comparison to the benchmark, this means that the absolute ratio of the company is above the benchmark and has outperformed.
What is known as a good price-to-earnings ratio?
Understanding whether the price-to-earnings ratio is good or not depends on factors such as the current market conditions and the nature of the industry that the company is a part of.
While this assessment is done, investors need to compare and take other companies that are similar with the same growth phase.
For example, if Company X has a price-to-earnings ratio of 30% and Company Y with the same kind of characteristics has a P/E ratio of 10%. This means that Rs. 30 will have to be paid for Re. 1 of the shareholder’s earnings. For company Y, shareholders will need to pay Rs 10 for Re. 1 of the earnings. This is why Company Y allows higher gains and is more profitable.
Higher ratios may be risky while ratios that are lower may indicate underperformance of companies due to internal issues that may be in place.
What are the limitations of P/E ratio?
- It does not tell investors anything about the company’s EPS growth prospects.
- It is difficult to utilise the P/E ratio when it comes to comparing companies that are from different industries.
- P/E ratio uses Earnings Per Share (EPS) which may not be accurate and could mislead individuals. Positive earnings can be reported with negative cash flow and this shows that more is being spent than what is earned. This is mainly due to different accounting methods that are present.
A commerce graduate who is on a mission to educate people about investment and personal finance.