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Price to Earnings Ratio | Types, Formula and Limitations

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Introduction:

When you buy a piece of gold jewelry, you know the current price and pay according to the same ongoing rate. Even with other purchases, we check whether it is worth buying at that MRP and at what cost. For all such purchases, we know the actual value of the commodity, which is why we readily pay the asked price. 

A tool called the PE ratio, one of the important financial ratios, lets us make a similar evaluation when buying shares or stocks. What is it? How does it work? How do you analyze stocks using the P/E ratio? Let’s understand.

What is the P/E Ratio?

The Price-to-Earnings (P/E) Ratio compares a company’s stock price to its earnings per share (EPS). It helps investors understand a company’s value and market expectations. Simply, it shows how much you need to pay for each unit of the company’s current or future earnings. 

The P/E is helpful because it compares stocks with different prices and earnings levels. It is often called an earnings multiple and has three types. Let’s look at all three with an example. 

Say Company ABC’s current stock price is Rs.120, projected earnings for next year are Rs.12 per share, past one-year earnings are Rs.10 per share, and inflation-adjusted average earnings over the last 10 years are Rs.8 per share. 

    Forward P/E Ratio

    This ratio looks at a company’s expected future performance. It compares the current stock price to projected future earnings, as estimated in earnings guidance. As per the example, the forward P/E ratio for Company ABC will be 

    Forward P/E = Current Stock Price ÷ Projected Earnings = 120/12 = 10

    This says that the investors are paying Rs.10 for every rupee of projected future earnings. While it gives a glimpse into potential growth, these estimates can sometimes be inaccurate.

      Trailing P/E Ratio

      The trailing P/E focuses on the past. It calculates the ratio using earnings data from the last 12 months. So, continuing the example, the trailing P/E for Company ABC will be 

      Trailing P/E = Current Stock Price/ Earnings of the Last 12 Months = 12

      This says that investors are paying Rs.12 for every rupee of past earnings. While it reflects balanced actual performance, it may not always reflect the company’s future earnings potential. 

        The Shiller P/E Ratio

        Also known as the cyclically adjusted price-earnings ratio, this method uses a company’s average earnings over a set period. The Shiller P/E calculates the current stock price divided by the company’s inflation-adjusted average earnings over the last ten years. So, for Company ABC,

        Shiller P/E = Current Stock Price ÷ Inflation-Adjusted Average Earnings = 120/8 = 15

        This means the investors pay Rs.15 for every rupee of long-term, inflation-adjusted earnings. It says the stock price is higher than long-term earnings, possibly due to market optimism or economic cycles.

        Apart from these, another classification of the P/E ratio divides it as

          Absolute P/E Ratio

          The absolute P/E ratio is the traditional method of calculating the Price-to-Earnings ratio. This method divides a company’s current stock price by its past or future earnings. 

            Relative P/E Ratio

            The relative P/E ratio takes things a step further. It compares a company’s absolute P/E ratio with a benchmark or past P/E ratio. Investors use it to gauge a company’s performance over time or against industry standards.

            Let’s take HCL Technologies as an example. As of 2nd January 2024, the sector P/E stands at 37.87, while the company’s P/E is 31.23. The relative P/E ratio of 82.47% indicates that the company’s P/E is lower than the benchmark sectoral ratio. If the company’s P/E had been higher than the sector’s, say 40.13, the relative P/E would have been 105.97%, suggesting the company has outperformed the sector.

            Generally, a relative P/E ratio below 100% implies that the company’s P/E is lower than the benchmark, potentially indicating the stock is undervalued. Conversely, a relative P/E ratio above 100% suggests that the company has outperformed the benchmark, which may indicate the stock is overvalued or performing exceptionally well relative to its peers.

            This comparison helps you understand whether a stock is undervalued or overvalued compared to its peers or historical performance.

            How To Calculate The P/E Ratio?

            The formula used for computing the P/E ratio is-

            P/E = Current Market Price of a Share / Earnings per Share

            Suppose a company’s P/E ratio is 37 times. This means that buyers are ready to pay Rs.37 for every rupee of profit earned by the share. The usual scale for measuring the P/E ratio is centered at 1. 

            Accordingly, a P/E ratio of 1 means the market values the company at its intrinsic value. A ratio above 1 suggests overvaluation, where the stock is priced higher than its earnings potential. In contrast, a ratio below 1 indicates undervaluation, meaning the stock is priced lower than its intrinsic value.

            However, the P/E ratio must be compared against the industry ratio as a benchmark. For example, company A’s P/E ratio is 56, and company B’s is 21. The industry P/E is, say, 33. In this case, the P/E is much higher than the standard measure scale, which is 1. However, as per the industry standard, company B is said to have a lower P/E ratio and is thus undervalued compared to its peers. 

            ALSO READ:

            How To Do Stock Analysis Using P/E Ratio?

            • High PE Ratio  

            A high PE ratio often signals investors expect the company’s earnings to grow. When stocks show strong growth potential, their PE ratios tend to rise. Investors are willing to pay a premium for these stocks, anticipating higher returns.  

            However, a high PE ratio can also mean the stock is overvalued. If it exceeds the PE ratios of similar companies or its historical average, it might reflect excessive optimism. While this could indicate strong growth prospects, it might also suggest inflated valuations. A rising PE ratio is sometimes driven by declining overall earnings and positive market sentiment.  

            Low PE Ratio  

            A low PE ratio might suggest that the stock is undervalued. This happens when the company’s earnings grow, but the stock price doesn’t rise proportionally. Such situations attract value investors, who see an opportunity to buy stocks with strong fundamentals at a discount, betting on future price increases.  

            Conversely, a low PE ratio might signal declining company earnings. Investors could interpret this as a warning sign, leading to skepticism about the stock’s growth prospects. A modest PE doesn’t always mean a bargain—it might reflect real concerns about the company’s performance.  

            So, what is a good P/E ratio? It depends on factors like the industry, market conditions, and a company’s growth prospects. Comparing it with industry averages and competitors helps assess it better. The PE ratio can also be paired with other financial metrics for investment strategies. 

            Bottomline:

            P/E is one of the fundamental parameters of stock analysis. It’s handy for comparing companies in the same industry, like comparing one telecom firm to another, and is easy to compute using financial calculators. The P/E ratio gives insights into market sentiment and potential investment opportunities. However, it’s not a standalone tool. It doesn’t factor in future growth, debt, or industry-specific details, so always pair it with other financial metrics for a clearer picture. 

            Which tools to pair it with? You can approach a registered stock advisory company to help frame an investment strategy using the right mix of parameters. 


            FAQ

            1. What is the accuracy of the P/E ratio?

              The PE ratio doesn’t directly tell you to buy or sell but helps gauge whether a stock or market is pricey or cheap. Take the Indian market, for example. The 12-month trailing PE for the Nifty is around 21.6 times, which is 6% higher than its 15-year average of 20.3. This premium makes some long-term foreign investors hesitant to invest in new funds.

            2. What does a negative P/E signify?

              A negative PE ratio means the company faces losses or has negative earnings. Even well-established companies experience this at times. It can happen for various reasons, like environmental factors beyond the company’s control.

            3. How does the P/E ratio determine market sentiment?

              The PE ratio often reflects market sentiment. During bull markets, investor optimism drives stock prices up, leading to higher PE ratios. In contrast, bear markets bring lower PE ratios as pessimism pulls stock prices down.

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            I’m Archana R. Chettiar, an experienced content creator with
            an affinity for writing on personal finance and other financial content. I
            love to write on equity investing, retirement, managing money, and more.

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