Why is P/E ratio important for investors?

By Angel Broking | Published on 23rd June 2021 | 154

Why is P/E ratio important for investors?

The price-to-earning ratio or P/E ratio is one of the most widely used and accepted metrics by investors and analysts to determine the stock valuation. It shows if the stock of a company is undervalued or overvalued, along with the comparison of the valuation with the benchmark or industry peers.

The most commonly used variable is the earnings of a company from the last 12 months or one year or sometimes with the expected income, commonly known as the forward P/E. It is also referred to as the price multiple of earnings.

The Price Earnings Ratio (P/E Ratio) is the relationship between the stock price of a company and its earnings per share (EPS). It is a popular and widely accepted ratio that gives investors a better vision about the value of the company. The P/E ratio shows what the markets are expecting and how much investors must pay per unit of current earnings.

Earnings of a company is an important parameter while valuing it’s stock as investors would want to know how profitable a company is and how profitable its future prospects are. The P/E ratio is used by investors to determine the market value of a stock as compared to the company’s earnings.

Long story short, the P/E shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E is an indicator that a stock’s price is high relative to earnings and possibly overvalued. Conversely, a low P/E is a potential indicator that the current stock price is low relative to its earnings.

How to Calculate P/E Ratio

The P/E ratio is calculated by dividing the value price per share of the company by it’s earnings per share.

Earnings per share or the EPS is the amount of a company’s profit allocated to each outstanding share of the company. It is the net income generated by the company, earned per share if all the profit was paid out to its shareholders.

EPS is an important parameter for traders, investors and analysts, reflecting the financial strength of a company. No one recommends investing in a loss making business. In the P/E ratio, ‘E’ stands for the per sharing earnings, or simply EPS of the company.

Price-to-Earnings ratio has a universal acceptance and handling in the investment community. In simpler terms, it shows the amount an investor is willing to invest in shares of a company to earn a single rupee from it.

For instance, if a company has a P/E Ratio of 30, investors are willing to pay Rs 30 in its stocks for a one rupee of their current earnings.

In other words, a high P/E ratio of a company may mean that it is expected to have increased revenue in the future. Analysts and investors are speculating the same, leading to a spurt in its current stock prices.

How to compare companies by P/E Ratio

Suppose, a company named Toro reported earnings of Rs 15 per share, and another company named Boro reported earnings of Rs 25 per share. Toro has a P/E ratio of 8 and Boro has a P/E ratio of 10.

In this scenario, buying shares of Boro is better because for an almost similar P/E ratio, the investors are fetching more earnings per share. For each share of Boro, investors are getting Rs 25, which is two thirds higher than the per share earnings of Toro.

Types of P/E Ratio

There are two major types of P/E Ratio which investors take into consideration. They are forward P/E ratio and trailing P/E ratio. Both types of the P/E Ratio depend on the nature or the timeframe of earnings. Let us have a detailed discussion on them:

  1. Forward P/E Ratio: It is calculated by dividing the prices of a single unit of stock of a company and the estimated earnings of a company derived from its future earnings guidance. It is also called an estimated P/E ratio as this ratio is based on the future earnings of the company. Investors use forward P/E ratio to assess how a company is expected to perform in the future and its estimated growth rate.
  1. Trailing P/E Ratio: It is the normally and commonly used metrics. Trailing P/E Ratio calculates the past earnings of a company over a period is considered. It provides a more accurate and objective view of a company’s performance as the picture drawn is more realistic.

There are two more types of P/E ratios that help investors to determine the ‘value’ and ‘performance’ of a company. Let us have a close look at them:

  1. Absolute P/E Ratio: When the current stock price of a company is divided by either its past or previous earnings.
  2. Relative P/E Ratio: When the absolute ratio of a company is compared against a benchmark P/E ratio of the sector or past price to earnings of respective peers from the industry.

This metrics is used by the investors to determine how a company is performing compared to its peers or the industry itself. For instance, if the relative P/E ratio of a counter is 80%, when compared to the benchmark P/E levels, it means that the company’s absolute ratio is lower than the industry.

Likewise, Relative P/E ratio higher than 100% implies that a business has outperformed the benchmark or the industry in the given time frame.

P/E Ratio in Value Investing

Principle of ‘value investment’ has been prevalent in the stock markets since ages, where investors employ the thesis to consider the intrinsic value of the underlying assets over the current market price of the stock.

P/E ratio is one of the primary tools used by the investors in this respect, which helps the investors to determine if a stock is undervalued or overvalued.

If the stock is trading at a higher P/E ratio, it highlights that the company’s share prices are higher than its current earnings and hence, are overvalued. Value investors refrain from putting their money in overpriced stocks as they signify higher risks and speculative activities. It also shows the inefficient fund management within the company. Such ‘expensive’ stocks are a trap as investors simply chase momentum in them.

On the flip side, if a stock exhibits less than average P/E ratio, it shows that the stock prices are relatively undermined to the company’s earnings and hence are called undervalues. Value investors are positive on such counters and pick such stocks at a lower prices and sell when the prices rise higher.

Value Investors hold the stocks for a longer term. Investors book profits when the company attains its full profitability. Before picking a stock from a particular sector, investors must understand the average industry P/E ratio as some industries demand premium valuations.

Limitations of P/E Ratio

P/E Ratio has its own limitations as its usage across the board is not viable.. Investors can not compare the companies of different industries as various industries can have a high degree of difference and divergence in the P/E ratios. There are many Fintech companies, enjoying supernatural valuations despite making losses. Such companies have a negative P/E ratio.

‘Cheap’ stock, which shall be considered as undervalued counters, are available at lower valuations for a reason. If a company is trading at a low P/E ratio, there is likely negative sentiment that must be researched further.

Investors must understand that the top performing stocks from a sector or an industry or the companies which enjoy monopoly status trade at a very high P/E Ratio. Some of Such companies are IRCTC, Titan Company, Hindustan Zinc, Hindustan Aeronautics, Marico, Pidilite Industries, Adani Green Energy, Bharat Heavy Electricals, Maharashtra Scooters, 3M India, Dixon Technologies.

The P/E ratio uses earnings per share of a company, which sometimes, can be misleading. Companies can report positive earnings via various means while having negative free cash flow. This means the expenses of the companies are more than their actual earnings. This is due to varying accounting methods.

Investors must understand that there is no single metric that can tell you whether a stock is a good investment. A complete homework and checking the counter on various parameters, help investors to come up with wise and sustainable investment strategies.