The price to earnings ratio (PE ratio) is a commonly used tool to determine if the company is over or undervalued in the market. It helps management and leadership define a relationship between a company’s stock price and its earnings per share. In this article we will deep dive into the significance of this ratio.
This article contains:
- Understanding PE ratio
- PE ratio formula
- The importance of PE ratio
- Understanding the types of PE ratio
- What is a good price-to earnings ratio?
Understanding PE ratio
This is the ratio of the current price of a company’s share with its earnings per share (EPS).
The most commonly used variable for the PE ratio calculation is the earnings of the company from the previous financial year. It is commonly used by investors to determine the relative value of their company’s shares in comparison to others in the same sector.
Furthermore, the P/E ratio is also used by investors to compare a company against its historical records as well as to compare aggregate markets against one another over a period of time. The ratio can therefore be estimated on a backward-looking or forward basis.
What this means is that the P/E Ratio can be used to:
- Compare a company’s financial performance with its past performance.
- Compare a company’s financial performance with that of others in the same business.
- Compare a benchmark index’s performance with its past performance.
- Compare a benchmark index’s performance with that of other similar indices.
The PE ratio is also referred to as price multiple or earnings multiple.
PE ratio formula
The formula and calculation used for PE ratio is as follows:
PE ratio = (Current market price of a share/earnings per share)
Let’s understand this with an example. The current price of XYZ Ltd. is Rs 1,350 per share and the earning per share (EPS) is Rs 50.
Hence, the PE ratio is Price/Earnings = 1350/50, which works out to 27.
The importance of P/E Ratio
Analysts and investors across the world swear by the P/E Ratio metrics for various important issues. Let’s list down a few:
- With the price-to-earnings ratio, you can determine the amount of money you want to invest in a single share of a company for Re 1 of its earnings.
- Investors who use “value investing” while transacting in the stock market consider the intrinsic value of the company’s underlying assets rather than its current market price. P/E ratio is one of the primary metrics used in such a situation, as it helps to determine whether a stock is overvalued or undervalued.
- A company with a high P/E Ratio is a sign of a company that is overvalued or one that is on a trajectory to growth. High P/E ratio of a company also determines that it is expected to have increased revenue in the future. Value investors avoid trading in overpriced stocks as it indicates high speculation. It is a sign that the company is prone to systematic risks from inefficient fund management.
- A company with a low price to earnings ratio indicates undervaluation of stocks. It also determines that the company will perform poorly in the future which ultimately leads to plummeting stock prices in the present.
If a stock has a lower than average P/E, it indicates that the stock prices are disproportionately valued to the company’s earnings, hence are undervalued. Such a situation can be considered as a positive indicator for investments, as you can acquire these stocks at a relatively lower price than their relatively higher-priced peers.PE ratio determines the amount of money to invest in and to understand the chronology of overvalued and undervalued stocks Click To Tweet
Understanding the types of PE ratio
Investors commonly use two types of PE ratio. These include—forward PE ratio and trailing PE ratio. The use of each type depends upon the nature of earnings.
Forward PE ratio
This ratio type is calculated by dividing the prices of a single unit of a company’s stock and the estimated earnings of a company derived from its future earnings.
As this ratio type is based on the future earnings of a company, it is also known as estimated PE ratio.
Investors usually use the forward P/E Ratio to evaluate how a company is expected to perform in the future and estimate its growth rate. This type is also useful for comparing current earnings to future earnings. Forward P/E ratio presents a clearer picture of earnings—without changes and other accounting adjustments.
However, there are certain shortcomings with the forward P/E metric—companies could underestimate earnings only to beat the estimated P/E when the next quarter’s earnings are announced. Other companies may exaggerate the estimate and later make changes going into their next earnings announcement. Moreover, external analysts may also provide estimates, which may diverge from the company estimates.
Trailing PE ratio
The trailing PE ratio is the most commonly used metrics by investors. It is calculated by dividing the current share price by the total EPS earnings over the past 12 mth.
This ratio type uses a company’s past earnings over a period. The trailing P/E ratio provides a more precise and objective view of a company’s performance.
You should be aware that a company’s past performance doesn’t indicate its future behavior. You should therefore consider committing money based on its future earnings power, not the past.
Remember, the trailing PE will be less reflective of changes if a major company event is driving the stock price significantly higher or lower.
The trailing PE ratio changes as the price of a company’s stock moves. This is because earnings are only released each quarter, while stocks trade day in and day out. This is one of the main reasons why some investors prefer the forward PE.
If the forward PE ratio is lower than the trailing PE ratio, it indicates that the analysts are expecting earnings to increase; if the forward PE is higher than the current PE ratio, analysts expect them to decrease.
The other two more types of P/E ratios that help in determining the performance of a company are:
Absolute PE ratio
This refers to the traditional PE ratio, where the current stock price of a company is divided by either past earnings or future earnings.
Relative PE ratio
With relative PE ratio, the absolute ratio of a company is compared against a benchmark P/E ratio, or the past PE ratio of respective companies.
The relative PE ratio is used by investors to determine the performance of a company to its past ratios or its benchmark ratios.
Let’s suppose, the relative PE ratio of a company is 90% when it has been compared with a benchmark PE ratio. This means the company’s absolute ratio is lower than that of the benchmark. Conversely, PE value that is higher than 100% indicates that a business has outperformed the benchmark index performance during the specified period.
What is a good price-to-earnings ratio?
This is one of the most commonly asked questions by investors. There are many other factors that need to be considered to determine the same.
Firstly, the goodness of a ratio depends on the current market conditions, the industrial average of PE ratios, the nature of the industry, and other factors.
Therefore, you should consider the performance of other companies from the same industry, with similar characteristics that also have the same growth trajectory.
For instance, if Company X has a PE ratio of 40 and Company Y from the same industry with similar characteristics has a ratio of 10 it indicates that the shareholders of company X have to pay Rs 40 for Re 1 of their earnings and shareholders of company Y have to pay Rs 10 for Re 1 of their earnings. This parameter provides an efficient yardstick to compare two companies.
High ratios indicate the risk of value trap investments and lower ratios may be associated with a company’s subpar performance due to internal faults.
Therefore, investors cannot rely on a foolproof PE ratio for investments in the stock market. You may also consider using other technical analysis indicators such as discounted cash flow, and the weighted average cost of capital to evaluate a company’s potential profitability.
Also include how a low PE ratio does not always mean the company is undervalued. It could also mean that the company is underperforming. So PE ratio in isolation is not enough.PE ratio in isolation is not enough, other technical analysis indicators such as discounted cash flow, and the weighted average cost of capital evaluate a company’s potential profitability Click To Tweet
You should know that the PE ratio has its own set of limitations. For instance, it does not consider the EPS growth rate of a company, which is why investors also use PEG ratio or Price to Earnings to Growth ratio. Secondly, the company’s earnings are released every quarter, whereas the stock prices fluctuate every day. Therefore, you cannot entirely rely on the P/E ratio to make an investment decision.
Lastly, while you can fairly estimate a company’s stocks with a P/E ratio analysis, however it is prone to fault. Do not use this as a standalone criteria for picking an investment, but use it with other popular financial metrics to analyze a company’s fundamentals and financial health.