Different types of price-to-earnings (P/E) ratios in investment analysis

If you want to spot an investment opportunity, you have the option to choose from different types of tools available for investment analysis in finance. Many investors have their favourite tools, and they combine the results from different tools to find viable investment opportunities. You can also try out different tools for investment analysis to find a handful that allow you to get potentially better returns. One of the first tools you can start using is PE Ratio.

Let’s understand PE Ratio and the different types of PE ratios.

• Table of contents

1. What is the P/E ratio?
2. Does this mean that a high PE ratio is always desirable?
3. What are the types of PE ratio?
4. How to use the PE ratio?
5. FAQ

What is the P/E ratio?

Price-to-Earnings Ratio (PE Ratio), also written as P/E Ratio, is a value that you get by dividing a company’s market value per share by its earnings per share. The PE ratio helps you get an idea of the relative value of a company’s shares.

For instance, if the PE Ratio of a company is 10, then it means that investors are willing to pay Rs. 10 in its stocks for each rupee of its current earnings.

Similarly, if the PE Ratio of a company is 14, then it means that investors are willing to pay Rs. 14 in its stocks for each rupee of its current earnings. (For illustrative purpose only)

Does this mean that a high PE ratio is always desirable?

Not always.

The PE Ratio of a company can be high for two main reasons: it is on a trajectory of growth or it is overvalued. This means that you need to use other tools to find out if this presents a viable investment opportunity or not.

Likewise, if the P/E Ratio of a company is low, it may mean that the company is undervalued at the time or that it is projected to perform poorly in the near future. With further analysis, you can find if the company is undervalued at the time and if it presents a suitable investment opportunity.

What are the types of PE ratio?

There are two main types of PE Ratios – Absolute and Relative:

Absolute PE ratio: This helps you compare different companies from the same industry sector. There are two types of absolute PE Ratios:

• Trailing PE ratio: The trailing twelve months price-to-earnings ratio is derived by dividing the current share price of a company by its Earnings Per Share (EPS) in the last four quarters.
• Forward PE ratio: In direct contrast with the trailing PE, the Forward PE ratio is derived by dividing the current share price of a company by its projected earnings per share for the next four quarters.

Relative PE ratio

The absolute PE ratio does not give dependable results when it comes to comparing two companies from different industry sectors or comparing a company against a benchmark. This is because different industries trade in different valuation ranges. In these cases, you can use the relative PE ratio to get dependable results.

Relative PE compares the absolute PE to a range of PE ratios from the past, usually the highest PE in the timeframe. For instance, if the present PE of a company is 16 and the highest PE was 20 in the past decade, then the relative PE will be 0.8. This relative PE ratio indicates how well the company has been performing in relation to a benchmark or its past ratios.

How to use the PE ratio?

You can use different types of PE Ratios to:

• Compare different companies in the same industry.
• Compare different companies in different industry sectors.
• Compare the PE ratio of the company at regular intervals during a longer time period for long-term valuation.
• Compare the valuations of stock indices as well as individual stocks.
• Evaluate a company’s performance against a benchmark.

In conclusion, the PE ratio can prove to be a useful tool in your investment analysis arsenal to find lucrative investment opportunities. The best part is that P/E Ratio is easy to calculate, and the results are easy to interpret. A high PE ratio indicates that either the company is near a growth trend, or the stock is overvalued, and it may not be the ideal time for investment. In contrast, a low PE ratio indicates that either the company is near a downward trend, or the stock is undervalued, and suggests a viable investment opportunity. You must use other tools to verify your findings before investing your hard-earned money. Also, it is always wise to consult a financial advisor before making any investment decisions.

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