The price-to-earnings ratio– P/E ratio for short– can be calculated on the basis of a particular stock’s current price divided by its EPS or earnings per share, usually over the preceding 12 months or the Trailing Twelve Months (following 12 months). Most P/E ratios are indicative of the stock’s present price as compared to its earnings over the last 12 months. For instance, a stock that currently trades at 40 rupees per share and comes with an EPS of 2 rupees will show a P/E of 20.
This would be similar to another stock currently quoted at 20 rupees per share and has an EPS of 1 rupee. Thus both stocks would have similar P/E valuation and investors would stand to pay 20 rupees for every rupee earned. However, should the case be such that a stock that is earning 1 rupee per share trades at 40 rupees a share, the P/E ratio would be 40 and the investor would have to shell out 40 rupees for a paltry earning of 1 rupee. This obviously is unacceptable but several factors could help mitigate this problem of overpricing.
Firstly, the company which has floated its shares could expect to grow its earnings and revenue faster in future than those companies having a P/E of 20, which helps it command higher prices today in anticipation of higher earnings in future. Secondly, supposing that the trailing earnings of the company with a 40-P/E are absolutely certain to happen in future as compared to the company with a 20-P/E with uncertain future earnings. This obviously indicates a much higher risk in terms of investment. Investors stand to face lesser risk issues if they invest in a company with assured higher earnings in future and this too, gives the company the liberty to command higher prices currently.
Secondly, it also needs to be borne in mind always that average P/E ratios vary from one industry to another. The typical scenario is that stocks of those companies that are stable and mature and have moderate potential for growth usually have low P/E ratios. On the other hand, companies belonging to younger, quicker-growing industries have higher P/E ratios. Thus, while comparing P/E ratios of two companies before making an investment, one needs to make a comparison of companies operating in an industry with similar characteristics. Purchasing stocks with lower P/E ratios could end up in a portfolio that would be loaded with just utilities stocks & would inevitably lead to poor diversification and exposure to unnecessary risk.
However, stocks that have higher P/E ratios can also make good investments. For instance, a company with a P/E ratio of 40 with an earning of 1 rupee per share in the last 12 months is expected to make an earning of 4 rupees a share, next year. This implies that the company most likely would record a P/E ratio of 10 in a year’s time, and this would be very cheap. It pays to remember that when you analyze P/E ratios you need to work out the premium payable for the company’s present earnings, and then decide if its expected growth can warrant such premium.