P E ratio has come to become one of the most important metrics used when assessing the health of a stock.

It is very important, no doubt.

But depending on it alone can be a huge mistake.

This is why you must understand what it exactly P/E ratio is, and how you should use it to assess a stock’s value.

## What is P E ratio?

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Most people involved in equity markets might have encountered the term “P E ratio” while dealing with stocks and mutual funds.

The general perception is that the price to earnings ratio is used to measure whether an underlying stock is undervalued or overvalued. But there are various elements while analyzing PE ratio that investors should understand.

Therefore, in this article, we will deep dive into one of the most common terms used in the financial markets – “PE ratio”.

Let’s Begin!

PE ratio highlights the relationship between the stock price of a company to that of its earnings per share. It tells us how many rupees we as investors are ready to pay for one rupee earnings of the company.

This is the reason why PE ratio is also termed as “Price multiples” or “Earnings multiple”.

### Formula for Price Earnings Ratio (P/E Ratio):-

Price per share/ Earnings per share (EPS)

Note: The EPS for a company can be calculated as the total earnings for the company divided by the no. of shares outstanding for that company.

Let us understand the concept of P/E ratio with the help of an example.

Consider this.

Stock A is trading at ₹100 and Stock B at ₹150.

Most people would believe that Stock B is overpriced.

But that might not be the case.

If the earning per share (EPS) for A is ₹2 and EPS for Stock B is ₹5, we can easily say that the Price Earning ratio for Stock A is 50 whereas that of Stock B is 30; highlighting the fact that Stock B is cheaper than Stock A.

Therefore, this ratio helps us to have a better sense about the value of a company.

Earnings are an important source of information because investors want to know how profitable a company is and can be in the future.

Further, if a company doesn’t grow and the current level of earnings remains constant, we can interpret the PE ratio as the time taken (no. of years) for the company to pay back the amount put in by the investor.

## Types of PE ratio

Apart from the basic Price to Earning ratio that we calculate to gauge a particular stock, there are other variants of PE ratio that can be calculated such as Trailing PE, Forward PE, and Justified PE etc.

1. Trailing PE ratio: Used most commonly, when the PE ratio for a company is calculated from the last four quarters earnings, it is termed as Trailing PE. This can be considered as the most accurate measure as it is calculated using the company’s actual performance.
2. Forward PE ratio: Many a time investors look at the analyst estimates of earnings for the next four quarters to project the PE ratio for a stock. The ratio so obtained is termed as Forward PE. For example, the stock price of Infosys currently is 700 and analysts expect the earnings in the next 12 months to be 70. Therefore the Forward PE for Infosys would be 10 times (700/70).
3. Justified PE ratio: Calculated as shown below:-

Dividend Payout Ratio/ (Required rate of return- Sustainable growth rate)

The justified Price Earning ratio is used to find the PE ratio that an investor should be paying for a stock based on the dividend payout ratio, rate of return that the company needs to grow at and the growth rate expected throughout the sustainable future.

Thus, if justified PE is more than the basic PE (Company stock price/ Earnings per share), the stock is considered undervalued.

This method of valuing the PE ratio of a stock is known as the common stock valuation method.

## What does the PE ratio indicate?

High PE ratio: A high PE ratio indicates that a company is considered to be growth stock.

It also means that investors are optimistic about the company’s earnings in the near future and therefore are willing to pay more for the stock.

However, there are two major disadvantages of a high PE ratio as discussed below:-

1. A high PE ratio can indicate that the stock price for a particular company is overvalued relative to its peers.
2. As high PE ratio is generally for growth stocks, these companies are highly volatile and unpredictable.

A high PE may signify that the stock is overvalued. However, some stocks such as Amazon, D-Mart which are trading with high PE ratios are still considered as quality picks now.

For these companies, parameters such as management, the potential for growth and fundamentals are so strong that a high PE multiple is not always advisable to look at.

Low PE ratio: Companies having a low PE ratio are quite often considered as value picks.

A low Price Earning ratio suggests that the stock is undervalued as it is trading at a low multiple as compared to its peers in the industry.

However, it also means that the company in question has poor earnings currently which is reflected in the ratio and hence the low price.

It is this low price which attracts the investors to buy such stocks in order to reap in the benefits once the markets identify its true value.

But investors should not always be lured by stocks having a low Price to Earning ratio.

Many small-cap stocks at a nascent stage have a low PE ratio but only some are able to drive growth in the near future.

Most of these stocks commanding low PE fail going forward (Example: Sunil Hitech Engineers, Suzlon Energy).

Also, the stocks that do well are not only because they are trading at low PE but the management quality and other key metrics such as fundamentals and product offered etc. is robust for such companies (Example: Meghmani Organics trading below the industry peers and still having a great potential to grow).

When a company has no earnings in a particular year or is posting losses, P/E can be expressed as “N/A”. Although it is possible to calculate a negative P/E, it is not practiced in common convention.

## The problem with PE ratio

Though an important tool in valuing stocks, PE ratio also suffers from a few limitations.

It is often said ratios should not be looked in isolation.

This is also true if an investor is looking at just the PE ratio for valuing of a particular stock.

Let us discuss the few pointers in detail!

1. The most common limitation of using PE ratio is that it cannot be used for comparing stocks of various sectors. The valuation and the growth rates for companies in different sectors might vary depending on the type, quality and time of earnings for these companies. For example, if I compare the PE ratio for an Information Technology or FMCG company (usually low PE ratio) to that of an energy or textile company (usually a high PE ratio), the ratio will not reflect the true picture. Comparing PE ratios of companies in different sectors is not an apple-to-apple comparison. Therefore, it is always advisable to compare PE ratios amongst companies in a similar sector. In this way, we can gauge whether the company in question is trading below the industry PE and other peers in the same sector, thereby helping us decide its true value.
2. The calculation of PE ratio involves earnings and the market price of an equity share and does not take into account the debt aspect for companies. Use of debt can significantly skew the PE ratio and hence is not a true measure of a company. There can be companies that are highly leveraged but the high PE ratio of these companies will not capture this aspect.
3. One more big assumption while calculating the PE ratio is that the earnings will remain constant in the coming future. There are various parameters based on which the earnings are dependent on and hence this assumption does not hold true in all cases.
4. The general conception is that a company with a lower PE ratio can be considered undervalued relative to its peers. However, while comparing the PE ratios we do not compare the quality of earnings for the company in question. If the company which currently is trading cheap has a poor quality of earnings, then it is not suitable for investment.

## How should we look at P E ratio when comparing equity mutual funds?

We all know that an equity mutual fund invests in a pool of securities (Comprising of IT, FMCG stocks which have low PE and at the same time might have investments in sectors such as energy, manufacturing etc.).

Therefore, the PE ratio for this fund will be a weighted average of the PE ratios of all stocks. As the portfolio of the fund changes so does the PE of the entire fund.

Note: Cash does not impact the PE ratio for the fund. Also, the loss-making companies should be assigned zero value while estimating PE ratio for a mutual fund.

Given these scenarios, a mutual fund’s PE ratio is dissimilar to that of a stock. But, the ratio can be used while:-

1. Comparing funds in the same category – For example when we are investing in value funds (In value-based approach, the fund manager hunts for companies that currently don’t enjoy premium in the markets but are fundamentally more strong than what the price indicates) we should know that the PE ratio for such funds will be less than that of growth funds (In growth based approach, the fund managers invest in stocks that are highly priced as these stocks exhibit healthy growth in profitability).
2. Comparing different categories – For example, when comparing a mid-cap fund to a large-cap fund we know that the PE ratio for mid-cap funds will be lower than that of a large-cap fund.

However, it should also be noted that we should not look only at the PE ratio to measure the kind of mutual fund.

It should be looked in tandem with the market capitalization.

For example, if a small-cap mutual fund has an average market capitalization less than that of its peers, it shows that the fund manager is taking higher risks as compared to the same funds in this category.

Similarly, a large-cap fund having stocks with a higher market capitalization suggests that the fund manager is not taking undue risks and investing in pure-play growth stocks.

## Conclusion

An investor can’t just comment on whether a stock is good or bad by looking at the PE ratio.

The PE ratio has to be seen along with various other factors.

When a stock has a high PE ratio, the investor expects that the future earnings will be upbeat.

Therefore, it seems that the stock is a good bet.

However, the reality might be quite different.

It might turn out that there is some bit of irrational exuberance amongst the investors for this stock and so not a good bet.

Similarly, when selecting a low PE stock we need to be sure that the stock is a fundamentally robust company and the PE ratio is low mainly because the investors have not taken note of this company.

Therefore, to become a sound investor we need to have a comprehensive understanding of various metrics used for gauging the performance of a company.

Happy investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.