Understanding price-to-earnings (P/E) ratio: A key metric for investment analysis

When newbie investors choose stocks to invest in, they do not always know how to do proper fundamental and technical analysis to find the right stocks. Some invest in stocks that are making news while others go with their gut feeling. Neither of these is a good investment strategy. The simplest tool available to investors to make the right choice is the P/E Ratio – full form: Price to Earnings Ratio. This useful metric can help investors spot investment opportunities.

In this article, we will discuss P/E Ratio: what it is, how it works and how you can use it.

• Table of contents

1. What is the price-to-earnings ratio (PE Ratio)?
2. How to interpret the price-to-earnings ratio?
3. What are the types of price-to-earnings ratio?
4. Absolute PE ratio and relative PE ratio
5. How to use the PE ratio?
6. FAQ

What is the price-to-earnings ratio (PE Ratio)?

When you divide a company’s market value per share with its earning per share, you get the Price-to-Earnings Ratio. Also referred to as the PE ratio or P/E ratio, it helps investors and analysts determine the relative value of the company’s shares. If the PE ratio of a company is 15 then it means that investors are willing to pay Rs. 15 in its stocks for Re. 1 of their current earnings.

How to interpret the price-to-earnings ratio?

Here is how you can interpret the PE Ratio meaning:

High PE: If you find that the Price to Earnings Ratio of a company is high then you can assume that the company is overvalued at the time or on a trajectory of growth. It may not be the right time to invest in the company’s stocks at this point.

Low PE: If you find that the PE Ratio of a company is low then you may assume that the company is undervalued at the time or that it is projected to perform poorly in the future. After combining the result from analysing other factors, you may find that it might be a suitable time to invest in the company’s stocks.

What are the types of price-to-earnings ratio?

There are two main types of PE Ratio:

Trailing twelve months (TTE) PE ratio: Sometimes referred to as Trailing PE, it is derived by dividing the current share price of the company by the last four quarterly Earnings Per Share (EPS). You can get a fair idea about the overall market in the present when you compare it with the past P/E ratios.

Forward price to earnings ratio: If you know anything about stock markets, you already know that past performance is not a good indicator of the future and may not necessarily repeat. Therefore, many investors prefer to use forward PE. It is derived by dividing the current share price by the projected EPS for over the four quarters.

Absolute PE ratio and relative PE ratio

TTE PE and Forward PE fall under the Absolute PE category. They help you compare two companies from the same industry sector easily. However, one of the limitations of using Absolute PE is that you cannot compare the P/E ratio of one company in an industry with another from a different industry. This is because different industries trade in different valuation ranges. In these cases, you can use Relative PE.

Relative Price to Earnings Ratio compares the absolute PE to a range of PEs from the past, usually the highest PE in the timeframe. For instance, if the present PE of a company is 18 and the highest PE was 20 in the past decade, then the relative PE will be 0.9.

How to use the PE ratio?

Now that you know what P/E ratio is and how to calculate it, here are three ways you can use it:

Compare different companies: You can use the P/E Ratio to compare different companies in the same industry to find out which one you should invest in.

Compare a company’s performance across a period of time: You can use PE ratio for the long-term valuation of a company. Just compare the PE ratio of the company at regular intervals during a longer period. For instance, you check the PE of the company for each year during the last 5 or 10 years.

Compare valuation of stock indices: You can use P/E ratio to compare the valuations of stock indices like Nifty 50 in addition to valuation of individual stocks.

In conclusion, the Price-to-Earnings Ratio is a simple way to find investing opportunities. It is also easy to calculate the PE ratio. A high PE may indicate that the stock is overvalued or near a growth spurt whereas a low PE may indicate that the stock is overvalued or near a downward trend. Additionally, you must use different tools and factor in other parameters to verify your findings before making the investment.

FAQs:

What is the Price-to-Earnings Ratio (P/E Ratio)?
The Price-to-Earnings ratio is a financial metric used to assess a company's stock by comparing its market price per share to its earnings per share (EPS). It provides insights into how much investors are willing to pay for each dollar of earnings.

How is P/E Ratio calculated?
To calculate the P/E Ratio, divide the market price per share by the earnings per share (EPS). EPS is the company's net income divided by the number of outstanding shares.

What does a high or low P/E Ratio indicate?
A high P/E Ratio may suggest that investors have high expectations for future growth, while a low ratio may indicate that the stock is undervalued or that the company faces challenges.

How can P/E Ratio be used in investment decisions?
Investors often use the P/E Ratio to compare a company's valuation to its peers or historical averages. It's a valuable tool for assessing the relative attractiveness of stocks within an industry.

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This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.