P/E Ratio or Price to Earnings Ratio is the ratio of the current price of a company’s share in relation to its earnings per share (EPS). Analysts and investors can consider earnings from different periods for the calculation of this ratio; however, the most commonly used variable is the earnings of a company from the last 12 months or one year. It is also referred to as price multiple of earnings multiple.
P/E Ratio Formula
P/E Ratio = (Current Market Price of a Share / Earnings per Share)
Price to Earnings Ratio is one of the most widely-used metrics by analysts and investors across the world. It signifies the amount of money an investor is willing to invest in a single share of a company for Re. 1 of its earnings.
For instance, if a company has a P/E Ratio of 20, investors are willing to pay Rs. 20 in its stocks for Re. 1 of their current earnings.
Hence, when a company demonstrates high P/E Ratio, it means that either the company is overvalued or is on a trajectory to growth. Another interpretation of a high P/E ratio could be that such a company is expected to have increased revenue in the future and speculation of the same by analysts and investors has led to a surge in its current stock prices.
On the other hand, a low Price to Earnings Ratio signifies undervaluation of stocks, due to any systematic or unsystematic risk of the market.
Considering a different interpretation of a low P/E ratio, it could also signify that a company shall perform poorly in the future due to which its stock prices are falling in the present.
Types of Price to Earnings Ratio
There are primarily two types of P/E Ratio which investors take into consideration – forward P/E ratio and trailing P/E ratio. Both these types of P/E Ratio depend on the nature of earnings, as enumerated below –
- 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. As such ratio is based on the future earnings of a company, it is also called an estimated P/E Ratio.
Investors use forward Price to Earnings Ratio to assess how a company is expected to perform in the future and its estimated growth rate.
- Trailing P/E Ratio
Trailing P/E Ratio is the most commonly used metrics by investors; wherein past earnings of a company over a period is considered. It provides a more accurate and objective view of a company’s performance.
Relationship between P/E Ratio and Value Investing
Investors who employ the principles of “value investing” while transacting in the stock market consider the intrinsic value of the underlying assets of a company rather than its current market price.
In case a company exhibits a high P/E ratio, it signifies that the company’s share prices are relatively higher than its earnings and hence, can be overvalued. Value investors refrain from trading in such overpriced stocks as it indicates high speculation, rendering the company prone to systematic risks arising from inefficient fund management. This approach allows investors to avoid a value trap.
On the other hand, if a stock exhibits lower than average P/E, it signifies that the stock prices are undermined in relation to the company’s earnings and are hence, undervalued. Value investors consider this scenario as a positive indicator for investments, as they can purchase these stocks at a lower price when compared to its intrinsic value and sell it at a higher amount later when such stock prices rise.
Value investing requires a long-term holding of stocks for investors to realise their profitability fully. It is also essential to note that individuals should consider the average P/E ratio of the industry a particular company belongs to before deciding whether its stock is overvalued or undervalued.
Absolute P/E Ratio and Relative P/E Ratio
There are two more types of P/E Ratios which help in determining the performance of a company.
- Absolute P/E Ratio
It refers to the traditional P/E ratio, wherein the current stock price of a company is divided by either past earnings or future earnings.
- Relative P/E Ratio
In the computation of relative P/E ratios, the absolute ratio of a company is compared against a benchmark P/E ratio or the past Price to Earnings of respective companies.
It is used by investors to determine how well a company is performing in relation to its past ratios or its benchmark ratios. For instance, if the relative P/E ratio of a company is 90% when it has been compared with a benchmark P/E ratio, it means that the company’s absolute ratio is lower than that of the benchmark. Conversely, P/E value higher than 100% implies that a business has outperformed the benchmark index performance during the specified period.
What is a Good P/E Ratio?
A question that riddles investors when using P/E ratio to decide where to invest is that what can be considered as a good or safe ratio. However, it is essential to note that the goodness of a ratio varies depending on the current market conditions, the industrial average of P/E ratios, nature of the industry, etc.
Hence, when investors assess different P/E ratios, they should consider how the other companies in the same industry with similar characteristics and in the same growth phase are performing.
For instance, if Company A has a P/E ratio of 40% and Company B with similar characteristics in the same industry demonstrates a ratio of 10% it essentially means that shareholders of company A have to pay Rs. 40 for Re. 1 of their earnings and shareholders of company B have to pay Rs. 10 for Re. 1 of their earnings. Hence, in this instance, investing in Company B might be more profitable.
While high ratios are associated with the risk of value trap investments, lower ratios might indicate the subpar performance of a company owing to internal faults.
Hence, there is no foolproof P/E ratio that investors can rely on when investing in the stock market. In this respect, other technical analysis indicators such as discounted cash flow, the weighted average cost of capital etc. can be used to ascertain the potential profitability of a company.
Limitations of P/E Ratio
Although a fair estimation of whether a company’s stocks are overvalued or undervalued can be construed through P/E ratio analysis, it is, nevertheless, prone to fault.
Calculation of P/E ratio does not consider the EPS growth rate of a company, which is why investors also use PEG ratio or Price to Earnings to Growth ratio to decide which company holds more promise.
Another reason why the P/E ratio cannot be solely used to make an investment decision is that the earnings of a company are released every quarter, whereas stock prices fluctuate every day. Hence, the P/E ratio might not agree with a company’s performance for a long time, leaving enough room for error on investors’ part.
Hence, investors should never decide whether a company is worth investing in by merely analysing its P/E ratio. They should also consider a host of other factors which impose a great weight on the true worth of stocks. These include – whether the company’s respective industry is facing an economic crisis or experiencing a cyclical boom, the company’s past records, scale of the company (large-cap, mid-cap, or small-cap), EPS growth prospects, which industry the company belongs to, average P/E in share market, how companies of similar scale are performing, demand of the particular industry at present and in the future, etc.
In conclusion, P/E ratio shall only be used as a tool for comparing different companies of the same industry with similar characteristics rather than as a tool for comparing amongst companies from all sectors.