PE Ratio – Price to Earnings Ratio

Price to earnings ratio identifies the relationship between the stock price of a company and its earnings per share. The price earnings ratio is considered by the investors to have a better sense of the value of the company. 

What is Price to Earnings Ratio?

Price to Earnings ratio is a financial metric that ascertains the actual valuation of the stock prices with its earnings per share. PE ratio is one of the most important ratios for long term investors as it shows the expectations of the market as well as the price that must be paid per unit of current earnings of the company.

How to Calculate Price to Earnings Ratio?

PE ratio is calculated by dividing the current market price of a share by earnings per share of the company. This is one of the most important financial ratios calculated by the investors and analysts all across the world.

Formula:

PE Ratio = Current Market Price of a share / Earnings Per Share

The significance of Price to Earnings ratio is to identify the amount of money that an investor is willing to invest in a single share of the company for its earnings. A higher price to earnings ratio indicates that the company is overvalued or is on the path to growth.

Also, it can be identified with a good PE ratio that a company has increased revenue in the future which has led to a surge in its stock prices. Conversely a lower price to earnings ratio signifies undervaluation of stocks which can be due to market risks which warns the investors about the poor performance of the company in future which leads to a significant decrease in stock prices.

Good PE Ratio

As an investor you might be a little confused while deciding what PE ratio should be considered as a good or safe ratio while investing. A good PE ratio of a company can only be decided after comparing the ratio with other companies in the same industry with similar characteristics and in the same growth phase.

Let us understand this with the help of an example, suppose company A has a PE ratio of 30% and the company B in the same industry has a PE ratio of 10% which means the shareholders of company a has to pay Rs 30 to earn a single penny while the shareholders of the company be has to pay only Rs 10, this permits the investors to invest the amount in company B as it might be more profitable.

Types of PE Ratio

A standard Price to Earnings ratio is calculated by dividing the current market price by the earnings per share, however it has been classified into different parts to overcome the limitations of standard calculation. Here are the types of PE ratio:

Trailing Twelve Months PE (TTM) PE

TTM PE Ratio is ascertained by dividing the current share price by the last four quarterly earnings per share. Investors can easily calculate the TTM PE as the companies declare financial results including EPS in each quarter.

Forward PE

Forward PE Ratio is a difficult task as it considers dividing the current share price by the projected earnings per share over the next four quarters. It is a skillful task because it involves forecasting of sales, margins, profits and losses, and earnings per share. Investors and analysts estimate forward earnings based on the information received from company management and on their own research.

Absolute PE

When the current stock prices are divided by either the past earnings or future earning that is TTM PE ratio or Forward PE ratio. On the other hand, absolute PE has a major drawback that the stocks of different sectors trade in different valuation ranges. Just like the metal stocks looks more attractive as its Price to Earnings ratio as an industry is much lower than the PE ratio of an FMCG sector company. 

Relative PE

Relative PE overcomes the limitations of Absolute PE as it usually compares the current PE value to the highest value of the range. It compares absolute PE to a range of past PEs over a relevant time period that could be the past 10 years.

Benefits of PE Ratio

PE ratio helps investors to ascertain the valuation of stock prices for the purpose of investment. Some important benefits of calculating PE ratio are:

Easy Estimation

The formula to calculate PE ratio is quite simple which only counts the stock prices and earnings per share of the company. The ease of calculating Price to Earnings ratio is one of the reasons for its wide usage despite other metrics for investment analysis.

Identify Growth Potential

Identifying the PE ratio of a company aims to extract the company’s actual growth potential. If the PE ratio is high, it signifies that either the stock is overpriced or the company is on a growth trajectory. A low Price to Earnings ratio indicates the declining performance of the company.

Simple to Use

It is one of the simplest ratios to use as you can easily identify the viability of the investment right away ascertaining the high value or low value of the stock. This ratio guides you to gauge the real life performance of the company  and hence you can get better results from your investment with a proper calculation and analysis.

Limitation of PE Ratio

Though price to earnings ratio is an essential ratio to be calculated before investing into a company, solely relying on a single ratio to identify the value of the company could not be a fair estimation.

The calculation of PE ratio does not take into account the EPS growth rate of the company which forces investors to calculate the price to earnings growth ratio that offers more confidence to decide the company that holds more promise.

Investors cannot completely rely on Price to Earnings ratio for their investment decision as the earnings of a company are released every quarter however the stock price fluctuates regularly.

These are the reasons why investors should always consider other factors instead of considering only ratios.

The other factors that must always be included to identify the true worth of a company are to analyze the technical factors, go through the companies past records, EPS growth prospects, scale of the company and industrial factors as well if the industry that the company belongs to is facing an economic crisis or experience in a cyclical boom must be analyzed and considered.

Ignoring Technical Analysis

An investor cannot completely rely on the fundamentals to ascertain the true value of the company, technical factors play a major role to determine the buying or selling pressure in the security. This is the greatest limit while using PE ratio for analysis. Demand and supply approach, top down approach, sector support, EMA 20, EMA 50, multiple time frame analysis, and other technical factors enhance the decision making process for investment.

Also Read: Fundamental v/s Technical Analysis

The Final Thoughts

Price to Earning ratio is a financial metric used by investors to ascertain the true value of stock prices of a company for their investment. While relying completely on financial ratio does n;ot guarantee effective investment, investors should consider technical analysis through demand and supply approach, top down approach, multiple time frame analysis, sector support and several other factors to conduct a fair estimation.

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