The PE Ratio is derived by dividing the market price of a share by the earnings per share.
P/E ratio = price per share / earnings per share
iPhones, OnePlus, Samsung or Xiaomi – How would you know which phone is giving best value against its price? You will compare available features and list out pros and cons. Mathematically, speaking, if you could derive a value for each phone that is comparable at par, wouldn’t it make the task easier for you?
If only we could divide the features by prices and arrive at comparable values! While this may not happen in case of phones, it’s quite simple in case of stocks.
Price to earnings (PE) ratio does exactly that. You divide the price of a stock by its earnings per share, and you get the PE ratio. This helps you ascertain whether a stock is expensive or cheap against its peers. Read on for more clarity.
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PE Ratio Meaning
In PE ratio, P stands for price and E, earnings per share. PE ratio tells you how much the market is willing to pay for stock against its earnings per share.
The PE ratio standalone does not tell you much. You have to compare it with other companies in order to make a more informed and prudent investment call. You may also compare it with the historical PE ratio of the same stock.
We also have PE ratios for indices such as Sensex and Nifty. Their PE ratios indicate if the market is overvalued or undervalued.
One can readily check the latest and historical PE ratios for stocks and indices on websites such as investing.com, screener and moneycontrol, etc. These are available on NSE and BSE websites also.
PE Ratio Formula
The PE Ratio is derived by dividing the market price of a share by the earnings per share.
P/E ratio = price per share / earnings per share
Where, earnings per share = Profits after tax (PAT)/total number of outstanding shares
For example, price per share is Rs 500, total number of outstanding shares 1 crore and the company has earned Rs 10 crore profits in a year. This is how you will calculate it:
EPS = 10,00,00,000/1,00,00,000 = Rs 10
Now PE ratio = 500/10 = 50
If PE ratio is 50, it tells you that the market is willing to pay Rs 50 per share to earn Rs 1 per share.
Types of PE Ratio
Broadly, there are two types of PE ratio:
- 12-month trailing PE ratio
- 12-month forward PE ratio
12-Month Trailing PE Ratio
TTM (trailing twelve month) PE takes into account the current share price divided by the last four quarterly EPS. One can easily calculate TTM PE as quarterly data for the last four quarters will be available. Companies declare the corporate earnings including EPS every quarter.
12-Month Forward PE Ratio
Forward PE takes into account the current share price divided by the estimated EPS over the next four quarters. Not all can calculate forward PE as it requires knowledge to forecast earnings, sales figures and other fundamentals of a company. You find forward PEs in brokerage reports as research analysts estimate it on the basis of management commentary and their own research.
Forward PE is more important than the trailing PE as you make an investment in a company for its potential future growth, not what it has delivered in the past. Of course, past performance is important, but not of utmost importance.
What is a good PE Ratio for Stocks?
There is no range or estimate to define a good PE ratio. It differs for various sectors. The PE valuation metric will be quite different for IT companies compared to what it is for manufacturing or consumer durable companies. Hence no apple to orange comparison. Compare apples to apples.
First, check the PE ratios of all companies in a sector. Select the ones trading at lower PE ratios. Now look at historical PE ratios of these stocks and see where the current PE stands – closer to the higher end of the range or the lower.
If a stock is trading near the lower end of the range, it can be a good investment opportunity. However, PE valuation alone doesn’t guarantee a bargain deal. You must evaluate other factors too.
Typically, it is believed that the lower the PE ratio the better it is. But, this could also be because the company is not worth investing; hence the market is discounting it.
Higher PE sometimes means the marketmen are enthused about the future prospects of the company; hence they are paying a premium on it. Thus, PE ratio is subjective and should never be a standalone criterion to judge a stock.
We hope that you are clear about the topic. But there is more to learn and explore when it comes to the stock market, and hence we bring you the important topics and areas that you should know:
Quick Summary
PE ratio is an easiest and convenient way to derive the valuation of a stock or an index. But there are other valuation metrics too that must be compared along with the PE ratio such as price-to-book, debt-to-equity and cyclically-adjusted price-to-earnings ratio.
The PE ratio can give you an initial indication into the valuation of a stock, but the final call to buy and sell has to revolve around other factors.
