The Price to Earnings Ratio or P/E Ratio is the most popular metric for analysing the company’s valuation. In addition to showing whether the company is undervalued or overvalued, this valuation ratio helps to understand the company’s financial health compared to its peers and industry. Read our article to understand the P/E ratio, its types, interpretation and limitations.
What is P/E Ratio?
Price to Earnings Ratio or P/E Ratio depicts the relationship between a company’s share price and Earnings Per Share (EPS). Simply put, it denotes what the market is willing to pay for a stock based on the company’s past and future earnings. Also, this valuation ratio helps investors analyse whether the stock is undervalued or overvalued.
Earnings are essential as it helps in evaluating a company. This shows the company’s current profitability and also estimates how profitable the company will be in future. If the company’s growth and earnings remain constant, you can interpret the P/E ratio as the number of years it takes for the company to pay back the price paid for each share.
The P/E ratio is one of the most popular metrics that analysts and investors use worldwide. They consider earnings from different periods for the calculation of this ratio. Therefore, the other names for the P/E ratio are ‘earnings multiple’ or ‘price multiple’.
Recommended Read: What is Price to Book (P/B) Ratio?
Price to Earnings (P/E) Ratio Formula
P/E Ratio = Market Price of the Stock/ Earnings Per Share
How to Calculate p/e ratio?
For instance, the market price of a share of Company ABC is Rs. 100, and the earnings per share is Rs.10.
P/E Ratio = 100/10 = 10.
Therefore, the P/E ratio of the company is 10, which shows that investors are willing to pay Rs.10 for every rupee of company earnings.
What are the Types of Price to Earnings Ratio?
There are two types of price-to-earnings ratios that investors consider for evaluation. Both ratios depend on the nature of earnings, as explained below.
Forward P/E Ratio
The forward PE ratio is also known as the Estimated P/E ratio. It is calculated by dividing the current share price by the projected EPS over the period. Calculating this ratio requires expertise as it involves forecasting and budgeting the company’s sales, margins, profit & loss and EPS. Research analysts estimate this ratio based on the data received from company management and their research. Hence, investors can use this ratio to estimate the company’s future performance and growth rate.
Trailing P/E Ratio
The Trailing PE ratio is the most common metric used by investors. This ratio uses the past data of company earnings for analysis. Also, it provides a more accurate view of the company’s performance. Hence, it becomes easy to calculate as the company declares financial results every quarter.
Forward PE is more relevant than trailing PE because past earnings are already discounted in the company’s share price. On the other hand, forward PE can indicate how the future stock price changes. Also, past analysis of trailing PE provides insights into the stock price. Furthermore, it shows whether the overall market or market index is too low or too high compared to the previous PEs.
Interpretation of Price to Earnings Ratio
The P/E ratio varies depending on the sector. But you must compare this ratio with its peers having a similar business activity or its historical P/E to evaluate its stock value. Also, this ratio helps to understand if you are paying a fair price for the company’s stock.
Price to earnings ratio is the quickest way to value a company using earnings. This ratio makes it easy to assess what kind of company it is.
Negative P/E Ratio
A company that loses money or has negative earnings will have a negative P/E ratio. Some companies can have negative cash flows for periods due to reasons beyond their control. Therefore, you must avoid companies with negative P/E ratio consistently. Such companies can go bankrupt at any time. Also, certain companies do not disclose their EPS for some quarters, which can be a way to avoid showing negative P/E.
Justified P/E Ratio
The justified P/E ratio is different from the standard P/E ratio. As a result, the two ratios are different and produce different results. The company is undervalued if the P/E ratio is lesser than the justified P/E ratio. Hence, such stocks have the potential to generate profits over time.
Justified P/E Ratio = Dividend Pay-out Ratio / R – G
R – Required rate of return
G – Growth Rate
High P/E Ratio
Companies with a high P/E ratio can be considered growth stocks. A high P/E ratio can indicate a positive future performance, and investors can expect higher earnings growth in future. However, growth stocks are highly volatile. As a result, the companies are under pressure to perform better to justify their higher valuations. Therefore, a high P/E stock can sometimes be a risky investment and the company’s share price is overvalue.
Low P/E Ratio
Companies with low P/E ratio can be considered value stocks. In other words, these stocks can be undervalued, trading at a lower price than their fundamentals. On the other hand, low P/E can also indicate a company’s weak performance. Thus, this can be a poor investment choice for investors. However, investors must consider investing in these stocks only if the company fundamentals are strong. Investors can benefit from these stocks when the price appreciates.
Absolute PE Ratio and Relative PE Ratio
Absolute P/E Ratio
This ratio is similar to the traditional PE ratio, which you can calculate using either of the two methods, i.e. trailing PE or forward PE. However, this ratio has certain limitations. The major limitation is stocks of different industries have different valuations. For instance, the PE ratio of FMCG stocks is higher than that of metal stocks. But this does not indicate that metal stocks are cheaper than FMCG stocks making them more attractive. Therefore, you can overcome this limitation by using the relative PE ratio.
Relative P/E ratio
To compute the relative PE ratio, you have to compare the absolute ratio of a company with the benchmark P/E ratio or a range of past earrings over a period (such as 10 years) of respective companies. Therefore, investors use this ratio to measure the company’s performance in relation to past or benchmark ratios.
For instance, if the company’s relative PE ratio is 80% in comparison to the benchmark PE ratio, it indicates that the absolute ratio is lower than the benchmark. On the contrary, if the relative PE is higher than 100%, the company has outperformed the benchmark index during the specific period.
Limitations of Using Price to Earnings Ratio
Even though the Price to Earnings Ratio is a handy tool for the valuation of stocks, this cannot be the only criterion for evaluating a company’s earnings. You can use other valuation tools to arrive at the right picture. The following are the limitations of using this ratio –
- The calculation of the P/E ratio only includes earnings and the market price of the company’s share. It does not consider the debt aspect of the company. There are many companies with high debt, which can be risky investments.
- This ratio assumes that the earnings will remain constant only for a short period. However, earnings are dependent on other factors and can be highly volatile.
- Investors prefer to invest in companies that generate steady cash flows at an increasing rate. However, the P/E ratio does not give any information about the company’s cash flow. Therefore, investors must also use the PEG ratio to understand the company’s growth.
- The company releases its earnings every quarter, and the stock prices fluctuate daily. Hence, this ratio may not agree with the company’s performance for a long time, leaving room for error on the investor’s part.
- You must never decide to invest in a company stock based on a PE ratio. You must consider other factors before investing that add value for stock analysis. The factors include whether the respective industry is facing an economic crisis or cyclical boom, the company’s past records, average share market P/E, competitor analysis, the demand of a particular industry currently and in future and so on.
To conclude, you can use this ratio to compare companies within the same industry with similar characteristics rather than companies from all sectors. Also, no single ratio can give all the information about the stock. Using other ratios to arrive at a complete picture of a company’s financial health and stock valuation is essential.