What is Price to Earnings (P/E) Ratio: A Comprehensive Guide

2024-08-02

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Investing in a stock is an exciting yet overwhelming task requiring careful research to understand different stock’s performance. Basically, two factors affect the stock’s performance: the profitability of the underlying company and how investors value that profitability. An earning report can provide investors with details regarding profitability. But, a Price-to-Earnings ratio valuation is important to determine the value investors place on those profits.

Wondering what this is? This blog will provide details regarding what is PE ratio, how to calculate it, and what is a good PE ratio. Keep scrolling through to know the details.

Table of Content

0 1

Price-to-Earnings Ratio - An Introductor

0 2

Ways to Calculate the PE Ratio

0 3

Calculating PE Ratio: An Illustrative E

0 4

Impact of High Vs Low Price-to-Income Ra

0 5

What is a Good PE Ratio?

0 6

FAQs

Price-to-Earnings Ratio - An Introductory Guide

The Price-to-Earnings ratio or PE ratio is a metric used to analyse a company's current valuation in the market. Interpreting this ratio helps to determine the growth potential of the specific equity stock. Additionally, it accurately reflects the company's future earning potential with respect to its current stock price.

A key consideration of this metric is the relationship between stock price and earnings growth. If the stock price rises faster than earnings, the PE ratio becomes high, potentially signalling overvaluation. So, when predictions suggest growth in a company’s future earnings, the market price of its shares tends to rise.

While PE ratios are typically computed for individual stocks, they can also be calculated for stock indices and stocks held by equity mutual funds. However, due to the dynamic nature of stock prices, PE ratios for individual stocks and indices constantly fluctuate.

Ways to Calculate the PE Ratio

Forward Earnings: Under this method, the Price-to-Earnings ratio is calculated using the company's projected future earnings. Forward earnings calculation does not use the company's reported financials; rather, it carries a trend analysis of the financials to understand how markets expect the company to perform in the upcoming years.
Trailing Twelve-Month Earnings: This method uses the company's earnings over the preceding 12 months to compute the PE ratio. The benefit of trailing twelve-month earnings is that the ratio is derived from reported and credible data; thus, it accurately indicates the past trend of the company's performance. Since this method does not carry any prior beliefs and offers accurate results, many large-cap and mid-cap companies and large-cap mutual funds use this method to calculate the PE ratio.
Shriller PE Ratio: This approach involves utilising the company's average earnings over a specified period. Referred to as the Shiller ratio or cyclically adjusted price-earnings ratio, this method divides the current stock price by the company's average earnings from the past ten years, with adjustments made for inflation.

Calculating PE Ratio: An Illustrative Example

Now that details regarding the PE ratio and different ways of calculating it are clear, here is an illustrative example for a better understanding of the concept behind this.

The basic formula for calculating the PE ratio = Price per share/ Earnings per share

Here is the comparative analysis of the Price-to-Earnings ratio of 2 different companies.

	Company A	Company B
Price Per Share	₹250	₹300
Earnings Per Share	₹10	₹15
PE Ratio	250/10 = 25	300/15 = 20

This reflects that company B is cheaper because investors pay less for every ₹1 of the earnings per year. This PE calculation method can be used to evaluate and screen different investment options.

Impact of High Vs Low Price-to-Income Ratio

High PE Ratio:

Investors may expect higher future earnings: If the future earnings of stock are expected to increase compared to the current levels, the stock PE ratio will increase. A higher PE ratio goes hand-in-hand with such growth stocks. Thus, stocks selling at higher PE ratios have higher growth expectations, and investors are willing to pay higher premiums for current earnings.
Stocks may be overvalued: If a stock's PE ratio surpasses not only those of comparable companies but also its own historical PE ratio, it might be attributable to optimistic growth prospects. Nevertheless, this could also signify a potential overvaluation of the stock. Positive market sentiment often leads to elevated PE ratios, reflecting investors' keen interest in anticipated future growth. Conversely, PE ratios may rise even with a significant decline in overall earnings.

Low PE Ratio:

Stocks may be undervalued: A decreasing PE ratio could indicate a discrepancy between the stock price and the company's actual worth derived from its earnings. In such cases, the stock price may remain stable even if the company's earnings rise, leading to a lower PE ratio. Investors might see this situation as an opportunity to buy the stock, expecting its price to go up as its earnings improve. This approach aligns with the principles of value investing, wherein investing in companies with lower PE ratios aims to mitigate the risk of unmet future growth expectations.
Company earnings may have fallen: A modest PE ratio does not necessarily indicate undervaluation; it might be justified by prevailing distrust among investors regarding the stock's future earnings.

What is a Good PE Ratio?

The assessment of what is a good PE ratio depends on various factors, including the industry, market conditions, and the company's growth prospects. Benchmarking a company's PE ratio against its industry average and competitors is crucial for a more accurate assessment.

There is no universal answer for what is a good PE ratio; thus, an investor should consider it alongside other financial metrics and factors when making investment decisions. It's essential to analyse the specific context of the company, industry dynamics, and broader economic conditions.

Although this screening approach aids in identifying potential investments, it is crucial to consider not only the Price-to-Earnings ratio of stock but also to compare it with those of peer companies before reaching any investment decisions. Consequently, consulting with a financial analyst or investment advisor is recommended to ensure a well-informed investment strategy.

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