# PE Ratio

Let’s assume 1 kg of wheat costs Rs.X at the nearby supermarket. Now suppose, 1 kg of wheat represents one unit of a company’s earnings and price of Rs.X represents the market price of 1 share. So when you pay Rs.X to buy 1 share of a company, basically you are buying 1 unit of company’s earning by paying Rs.X. PE ratio is the price paid per unit of earnings and is calculated by dividing current market price by earnings per share. In our example, PE ratio would be X as X/1 = X.

You might have read that PE ratio of a stock is 25 or Nifty is trading at a PE ratio of 16. You might naturally wonder why anybody would pay that much to buy Rs.1 earnings. So it is important to understand that when you pay money and invest in a company,  you are eligible to receive a part of the earnings generated by the company, every year, as long as you hold the share.

Suppose the price of 1kg wheat of brand A is Rs 15 and that of brand B is Rs 20. You believe that both A and B are equally good quality wise. So naturally you will buy brand A wheat as it is cheaper. Similarly, let’s suppose there are two companies operating in the same sector and are expected to perform similarly in the future . A has a PE ratio of 18 and B has a PE ratio of 20. We can easily say that A is undervalued compared to B as it has lower PE ratio. It would be prudent to buy shares of A as we have to pay lesser amount per unit of earnings compared to shares of B.

Just as price of 1 kg wheat cannot be meaningfully compared to price of 1 litre of petrol or any other product for that matter, PE ratio of companies operating in different sectors cannot be meaningfully compared. Only PE ratio of companies operating in the same sector can be meaningfully compared to each other. One can also compare the current PE ratio of the company with its historical PE to deduce whether the stocks is currently undervalued/overvalued.