The price to earnings ratio is also known as the P/E ratio establishes a relationship between a company's per stock price and its earnings per share. The P/E ratio measures a company's share price related to its earnings.
However, the price to earnings ratio represents the investors are willing to pay for a stock per rupee of income. The P/E ratio helps to value a company.
PE Ratio Meaning
In simple words, The price to earnings ratio helps investors or analysts how many times earnings investors or analysts are willing to pay. Thus, the price to earnings ratio is also known as the price multiple or the earnings multiple.
P/E Ratio Formula
Generally, price to earnings ratio is calculated at the end of each year when annual financial statements are announced and the earnings per share are also calculated at the end of the year.
The price to earnings ratio formula is calculated by dividing the market price per share by earnings per share. The P/E ratio formula is given below:
P/E Ratio = (Market price per share/earnings per share)
Market Price Per Share:
The market price per share is the price per stock in the open market.
Earnings Per Share:
The earnings per share ratio imply that the percentage of a company's earnings is distributed to each outstanding share of a company.
Earnings per share are the net income of a company for the year divided by the total number of shares outstanding at the end of the year.
P/E Ratio Valuation
The P/E ratio is one of the most essential valuation tools that is used by investors or analysts for determining the value of the stock.
Also, the P/E ratio used for whether the stock price of a company is undervalued or overvalued. The main two components are the market value of stock and earnings per share.
The P/E ratio enables investors or analysts to determine the current market price of a stock as compared to the earnings of the company.
The price to earnings ratio can fluctuate depending on the market situations. A high P/E ratio can indicate that a stock's price is expensive relative to earnings and stock is overvalued.
Conversely, a low P/E ratio might demonstrate that the stock price is cheaper compared to the earnings of a company and the stock is undervalued.
Types of Price to Earnings Ratio
There are mainly two types of price to earnings ratio that take into consideration - forward P/E ratio and trailing P/E ratio. Both P/E ratios depending on the nature of earnings and discuss below:
1. Forward price to earnings ratio:
It divides the current share price of a company by the estimated future earnings of a company.
For valuation purposes, a forward P/E ratio is typically considered more relevant than a historical P/E ratio.
Investors obtain the forward price to earnings ratio to evaluate how a company is expected to perform in the future and its estimated growth rate.
Forward P/E ratio= (Current market price per share / Estimated future earnings)
2. Trailing price to earnings ratio:
It relies on past performance by dividing the current share price by the earnings over the past 12 months.
The trailing price to earnings ratio delivers a more valid scenario of a company's performance. The trailing price to earnings ratio changes when the stock price of a company moves.
Price To Earnings Ratio Example
Let, it is ABC company. The current market price of the stock is Rs. 30 and earnings per share are Rs. 5
P/E Ratio = (30 / 5)
P/E Ratio = 6 times
The price to earnings ratio is 6 means the investors are willing to pay 6 times more than the amount earned by the shares this year.
What does the Price to Earnings ratio tell you?
The price to earnings ratio is the market prospect ratio that shows what the market is willing to pay for a stock based on its current earnings.
The price to earnings ratio reflects the relation between the price of the share of a company and its earnings.
If a company's earnings per share rise then the market price also rises and if earnings fall, the market price also falls.
Hence, two are the main aspects of the company's actual performance and expansion.
A Company with a high Pe ratio may be considered to be growth stocks and it suggests the prospect of the company is good.
Investors have a higher expectation for future revenue growth and are willing to pay more for a company's shares.
However, a high PE ratio stock is to be considered overvalued and stock value may be uncertain to rationalize their higher valuation.
Therefore, investing in overvalued stocks will more likely be considered a risky investment.
Similarly, a company with a low PE ratio is considered to be an undervalued stock and it indicates the current and prospects of the company are poor. These could prove to be a poor investment.
Price to earnings ratio also indicates the poor earning capacity of the company which results in incompetent management efficiency and less profitability.
If you see the company's fundamentals are strong and the company earns profits over the year, then you must buy these company's undervalued stocks.
The price to earnings ratio varies from industry to industry, either should be compared to a related business with its peers and with its historical P/E to tell us whether a stock is undervalued or overvalued.
Generally, Investors or analysts prefer a high P/E ratio because of high expectations of stock but it depends on the companies which belong to which sector and the future growth of the business as well as sector.
What is a good price to earnings ratio?
A good PE ratio will depend on the quality of the industry, the company is operating in which industry and industrial higher average price to earnings ratios.
If you want to know if the particular P/E ratio is high or low, you have to compare it to the average P/E of the rival company within the same industry.
Let's understand with an example if M company has a P/E ratio of 28 and G company has a P/E ratio of 12, both are operating under the same industry.
It virtually indicates that shareholders of company M have to pay Rs. 28 for Re. 1 of their earnings and shareholders of company G have to pay Rs. 12 for Re. 1 of their earnings.
From this can conclude, investing in Company G might be more profitable than M.
A company with a high PE ratio may be considered a risk of a value trap investment. While a lower pe ratio indicates the deficient performance of a company with internal drawbacks.
Remember, price to earnings ratio doesn't give a factual technique of whether the stock is overvalued or undervalued. Investors can't make any decisions based on the one ratio.
In that case, another technical method such as discounted cash flow, the weighted average cost of capital, etc. can be used to determine the likely profitability of a company.
What does the negative P/E ratio indicate?
A negative pe ratio may indicate that is negative earnings of a company. For instance, well established large-cap companies may undergo intervals of negative cash flow due to aspects beyond their control.
However, those companies have negative PE ratios over the period, investors should be avoided, those types of companies and companies may go bankrupt.
If a company is not announcing earnings per share for some quarters. In this way, they might resist demonstrating a negative pe ratio.
What are the limitations of price to earnings ratio?
The price to earnings ratio tells investors whether the stock is worthy of buying or not. The price to earnings ratio has several limitations that investors take into consideration. The limitations are following:
1. Only the P/E ratio cannot provide investment decisions, because the profit/loss statements of a company are published every quarter whereas the stock price moves every day.
Therefore, the P/E ratio can not provide an accurate picture of a company's performance for a long time.
2. A low P/E ratio implies that a company's stock price is undervalued in the market for a short time and allows buying.
But a low P/E can also mean that the company might confront the problem in future and intelligent investors dumped the shares to prevent the losses.
3. The P/E ratio does not take into account the growth rate of a company's EPS. For this reason, investors also evaluate the price-earnings to growth ratio which gives an idea to the investors whether the stock holds or not.
Price to earnings ratio is a valuation metric that can be only used for comparing various companies within the same industry.
For instance, sectors like information technology, telecom companies have a higher P/E ratio compared to companies from other industries like manufacturing, textile, etc.
Thus, it is inevitable to check the background of the company considering all the aspects before investing.
