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Price-to-Earnings (P/E) Ratio: Definition, uses and formula

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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.

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What is the meaning of Price-to-Earnings (P/E) ratio?

The P/E ratio essentially tells us about the price an investor is willing to pay for a stock relative to the company's past or projected earnings. Price-to-Earnings ratio (P/E ratio) compares the common stocks’ current market price with respect to EPS. Sometimes, this helps investors determine whether the company is fairly or highly valued.

What is the P/E ratio formula?

The Price-to-Earnings (P/E) ratio is calculated by dividing a company’s current stock market price per share by its earnings per share (EPS). The formula is as follows:

P/E ratio = Market Price per Share / Earnings per Share

  • Market price per share: This is the current price at which a company's shares are trading on the stock market.
  • Earnings per share (EPS): This is the net profit of a company divided by the total number of outstanding shares.

How to calculate P/E ratio?

The P/E ratio offers a simple way to assess the market's valuation of a company in relation to its earnings. To calculate the P/E ratio, you need two pieces of information: the market price of a share and its earnings per share (EPS). The PE ratio formula is as following:

P/E Ratio = Market Price Per Share / Earnings Per Share (EPS)

As an example, consider company XYZ. Suppose the current market price of its share is Rs. 100. Over the last financial year, company XYZ reported earnings per share (EPS) of Rs. 10. When we add these values into the formula, this is what we get:

P/E ratio = 100 / 10 = 10

This means that for every rupee of earnings the company XYZ generates, investors are willing to pay Rs. 10. In essence, it provides a valuation multiple. Additionally, EPS is a significant component of the P/E ratio. It is calculated as:

EPS = Net Earnings / Number of Outstanding Shares

‘Net Earnings’ refers to the total profit of the company after deducting all expenses, including taxes. ‘Number of outstanding shares’ represents the total number of shares that are currently held by all shareholders.

How to interpret the Price-to-Earnings Ratio?

Here is how you can interpret the PE ratio:

  • 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 results from analyzing 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 P/E Ratio:

  • Trailing twelve months (TTM) P/E 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: Many investors prefer to use forward PE, which is derived by dividing the current share price by the projected EPS for the next four quarters.

Absolute P/E Ratio and Relative P/E Ratio

TTM 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 P/E Ratio?

Now that you know what the 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 the PE ratio for the long-term valuation of a company by comparing the PE ratio at regular intervals during a longer period, such as over the last 5 or 10 years.
  • Compare valuation of stock indices: You can use the P/E ratio to compare the valuations of stock indices like Nifty 50 in addition to the valuation of individual stocks.

Factors influencing the P/E Ratio

The P/E ratio is influenced by a range of factors, including company earnings growth, market conditions, economic outlook, and investor sentiment. Understanding these factors helps investors gauge the ratio's significance and make better investment choices.

  • Industry Norms: Depending on risk considerations and growth forecasts, various sectors may have varying average P/E ratios. When analyzing a company's P/E ratio, industry benchmarks must be considered.
  • Market mood: Variations in the market's mood may affect P/E ratios. For instance, in optimistic times, investors could be prepared to pay greater multiples for equities, raising P/E ratios.
  • Profits quality: When analyzing the P/E ratio, assessing the quality of a company's profits is essential, considering aspects like sustainability and consistency. One-time or unusual occurrences have the potential to skew profit data.

This way, investors get informed to make more rational decisions about P/E ratios and the relative value of a particular firm. Although the PE ratio helps determine an investment's financial situation and worthiness, one cannot solely rely on this ratio. One should include a PE ratio alongside other financial measures and variables for a holistic examination of a company's investment probes.

Common misconceptions about PE ratios

  • High P/E ratio always indicates overvaluation: A common misconception is that a high P/E ratio always implies that a stock is overvalued, while a low P/E ratio is always suggestive of undervaluation. However, this is not necessarily true. P/E ratios vary across industries and sectors, making direct comparisons unreliable. A high P/E ratio may also reflect strong growth prospects or investor optimism, while a low P/E ratio could signal market pessimism or poor fundamentals.
  • Static P/E ratios provide accurate valuation: Another misconception is that static P/E ratios provide a reliable measure of valuation. In reality, P/E ratios are dynamic and influenced by various factors such as earnings growth, market sentiment, and economic conditions. Failing to account for these dynamic factors can lead to inaccurate assessments of stock valuation.
  • Lower P/E ratios always indicate better investment opportunities: Some investors believe that stocks with lower P/E ratios always present better investment opportunities. While low P/E ratios may indicate undervaluation, they could also refer to underlying issues such as weak growth prospects or financial instability. It is essential to consider other factors alongside P/E ratios when evaluating investment opportunities.

Debunking PE ratios market efficiency

  • Efficient market hypothesis and P/E ratios: The Efficient Market Hypothesis (EMH) states that stock prices already factor all known information, so it's hard to beat the market consistently. Thus, in a theoretically efficient market, P/E ratios will adjust promptly to new information, making stock valuations fair. However, some investors believe that the markets do not always behave efficiently, thus allowing them the chance to use P/E ratios to find mispriced assets.
  • Behavioural biases and market inefficiencies: Behavioural biases like herding, reacting too strongly, and sticking to past beliefs can cause market inefficiencies and affect P/E ratios. When investors act irrationally, stock prices may not reflect their true worth. This gives investors a potential opportunity to spot undervalued stocks using P/E ratios.

Strategies to Optimise PE Ratios Market Efficiency

  • Comparative analysis: Instead of relying solely on absolute P/E ratios, investors should conduct a comparative analysis within the same industry or sector. Comparing a company's P/E ratio to its peers provides insights into relative valuation and helps identify outliers that may warrant further investigation.
  • Forward P/E ratios: Forward P/E ratios consider analysts' predictions for future earnings, giving insight into potential stock value. They factor expected earnings growth, offering a more detailed view of valuation and helping investors predict future market trends.
  • Fundamental analysis: Combining P/E ratios with other fundamental analysis metrics such as earnings growth, revenue trends, and balance sheet strength enhances the accuracy of valuation assessments. Fundamental analysis provides a comprehensive view of a company's financial health and growth prospects, allowing investors to make more informed investment decisions.

Read Also: Pros and cons of Price-to-Earnings (PE) ratio

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 undervalued 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.

What factors should be considered in addition to PE ratios when evaluating a stock?

In addition to PE ratios, investors should consider factors such as the company's growth prospects, industry trends, management quality, financial health, competitive positioning, and macroeconomic conditions.

Is the market always efficient?

While the Efficient Market Hypothesis suggests that markets incorporate all available information and prices reflect intrinsic value, critics argue that markets can be inefficient due to factors like behavioural biases, information asymmetry, and irrational investor behaviour.

What is the significance of the P/E ratio in stock analysis?

The P/E ratio is a crucial valuation metric that indicates how much investors are willing to pay for each rupee of a company's earnings. A higher P/E ratio typically suggests that investors have higher expectations for future earnings growth.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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