The PE (price to earnings) ratio is a commonly used ratio for stock selection. The ratio helps to ascertain the value of a company based on the current stock value per share for every rupee of its future earnings. P/E ratio helps to understand the company’s worth today and growth anticipated based on how its share prices are relative to its earnings per share.

One of the widely used tools for market evaluation, the PE ratio has been an effective determining factor for investors to base investment decisions on. If a PE ratio is high, investors deduce that the stock is overvalued and sell the shares or refrain from buying. In case the shares are undervalued, investors purchase them at lower rates to claim profits when the unrealised value is tapped. While the average PE noted to date is 14, it could vary from company to company across industries.

PE calculation and example:

To calculate the P/E ratio, one should divide the present stock value by the earnings per share (EPS). The present stock value (P) can be gathered from any financial website online by checking the current trading value of the company’s stock. This factor determines what investors are currently willing to trade for the company’s stock and is always an absolute number. EPS, on the other hand, is an estimated figure with multiple interpretations.

The formula and calculation used for this ratio are as below:

 

P/E Ratio = Market value per share / Earnings per share

 

EPS or Earnings Per share can be estimated in two different ways. The first is an estimate, otherwise known as PE TTM, where “TTM” is an abbreviation for “trailing in the past 12 months.” This number depicts the company’s performance in the course of the last one year. In case, stock investors are keen on long haul valuation, they analyse the P/E 10 or P/E 30 measures of a company. These measures give an indication of the company’s profits over the past 10 or 30 years.

The second type of EPS is based on the organization’s profit expectations. It takes into account the best-estimated call of the company on how it expects its earnings to be in the near future.

Types of PE ratios:

Depending on the two different ways of calculating EPS, there are two types of PE ratios – Trailing and Forward-looking.

Trailing Price to Earnings:

The trailing P/E depends upon the past performance of a company by dividing the recent stock price by the total EPS earnings over the past year. It is one of the most reliable and popular PE metrics as it uses actual data of the company’s profits. Prudent investors take the trailing PE as the basis of most of their financial decisions as the future earnings estimates could be unreliable. However, investors must remember that a company’s past performance does not necessarily guarantee its future behaviour.

Also, the trailing P/E ratio is not reflective of real-time company scenarios. While trailing P/E ratios include the latest movement of the price of a company’s stock, the earnings used are still the last reported quarterly earnings. So, while the stock price that moves every few hours might capture the latest updates within the company, the trailing P/E ratio remains more or less constant as the EPS is dated. For this reason, some investors prefer the forward P/E over the trailing PE.

Forward Price-To-Earnings

The forward (or driving) P/E utilizes estimated future income as opposed to trailing earnings figures. It is also known as the estimated cost to earnings. This indicator is valuable for providing a base of comparison between the current income and future income and gives a clearer image of what and how the company’s profits will pan out.

Though FPE is a reliable measure in assessing the future earnings of a company, FPE has certain limitations. Organizations can manipulate by underestimating their earnings in an attempt to outperform the estimate PE ratio when the quarterly gains are announced. Or overestimate P/E to push stock prices higher and miss earnings estimated. Such estimation causes a stock to be overvalued or undervalued, and investors never realize the expected returns.

Relationship between forward and trailing P/E ratio:

While both forward and trailing P/E ratios have their own advantages and limitations, investors must use them prudently, depending on their overall investment strategy and current portfolio.

If the forward P/E ratio is less than the trailing P/E ratio, it translates that investors expect the earnings of the company to increase and vice versa.

Using PE ratios to determine Investment Strategies:

PE ratios help in share selection. A low trailing P/E of a promising company’s stock could be an excellent investment. While a high P/E usually indicates that the price is overvalued compared to the earnings of the company. However, several high growth companies have higher P/E ratios, such as technology companies, as the growth potential estimated by investors on such stocks could be higher. Similarly, if the economy is booming, a high ratio does not mean the shares are overpriced as the overall market sentiment is positive. So, while P/E ratios are used to select stocks, careful estimation and relative assessment of the total ratio reap profits in the long run.

Comparing Companies Using the P/E ratio:

PE ratio can be used to compare the prices of stocks of companies belonging to the same sector, industry, and who are exposed to the same socio-economic factors. If Company X and Company Y are selling their commodity at Rs.100, the P/E ratio could still be different as it is dependent upon the profits generated and how the stocks have grown for each organization. The earnings of both companies can differ. For example, X might have reported revenues of Rs. 20 per share, which means a PE ratio of 5, and on the other hand, Y has an earning of Rs. 30 per share, PE ratio is 3.33. Y is cheaper, and the investor chooses to buy Y’s stocks because the ROI is higher.

Sector-wise PE ratios: 

PE ratios could vary from industry to industry – what is considered as the benchmark for the automobile sector may be too low for a technology sector company.

A plausible way of determining if a sector or industry is overpriced is when the average PE ratio of all the organisations in that sector or industry have values much more than the historical P/E average.

While investing, stock marketers gauge the market value of the industry, in general, to understand how a sector is faring and then compare it to the individual company’s stock price to make a calculated judgment.

Limitations:

Interpretation of the PE ratio depends upon the comparison of a company alongside its peers and competitors. It is wise to keep in mind that a particular PE, which is considered high in specific industries, can be very low in others. For instance, IT players and telecommunication companies have higher PE ratios compared to textile or manufacturing sectors.

Another thing to understand is that whenever there is a significant acquisition by a company, this pushes up its PE. On the contrary, a lower PE may indicate bad news as it can signify serious issues being faced by the company. Thorough research is to be done about a company or a sector before taking up a significant investment decision.

PE ratio is not the be-all, and end-all indicator of a company’s annual performance as the performance is subjected to other external factors such as economic conditions, leadership efficiency, operational challenges, competition, and more.

Conclusion :

PE ratio is an essential tool to understand the company and market behaviour at any given point in time. Investors and companies rely on this ratio to make financial decisions and effectively value their stocks based upon the share market Value and earnings to date or future earnings. PE ratio, though a comprehensive metric to evaluate a specific company’s worth, can be inconsistent at times due to the fluctuating stock prices or earnings.

Now that we know what PE in stock market is, a well-researched and informed approach should be followed when investing. Reach out to our experts to know more about equity trading.