The price-to-earnings (or P/E) ratio is a measure of how much investors are interested in paying for a single unit of a company’s earnings. It is calculated by dividing the current market price (CMP) of a company's share by its earnings per share (EPS). Several analysts and investors use this ratio to check whether a stock is overvalued or undervalued. Generally, this evaluation is done based on the earnings from the last 12 months.

A high P/E ratio signals that the stock is expensive or investors expect high future growth. Ont he other hand, a low P/E ratio shows that the stock is undervalued or has lower growth prospects. This way, by using the P/E ratio, you can assess a stock fundamentally and do value investing.

In this article, let’s understand the calculation of the P/E ratio and its various types. Also, we will learn how you can do value investing using it.

• The P/E ratio determines if a stock is overvalued or undervalued.
• A high ratio suggests overvaluation, while a low ratio indicates undervaluation.
• The forward P/E ratio uses estimated future earnings, while the trailing P/E ratio relies on past earnings.

The P/E Ratio is calculated by dividing the current market price of a company's share by its earnings per share (EPS). Mathematically, it can be represented as follows:

This ratio shows how much investors are ready to pay for each unit of a company's earnings. For example,

• Say a company's share price is Rs. 20
• Its EPS is Rs. 1
• In this case, the P/E Ratio would be 20
• This means investors are prepared to spend Rs. 20 for each Rs. 1 of the company’s earnings.

There are two main types of the P/E ratio: the forward P/E ratio and the trailing P/E ratio. Both are widely used by investors to evaluate stocks. Let’s study them in detail:

• Forward P/E ratio

The forward P/E ratio is calculated by dividing the current market price by “estimated future earnings”. This ratio uses estimates of projected earnings to determine a company’s future performance. Sometimes, the results delivered by this type of P/E ratio are unreliable, as it uses forecasts that can change based on market conditions.

• Trailing P/E ratio

The trailing P/E ratio is the more commonly used type. It is calculated using the company's past earnings over the last 12 months. This ratio provides a snapshot of how the company has performed historically and offers a clearer and more objective view of its past financial performance.

Most value investors focus on the intrinsic value of a company's assets and not just its market price. To do so, they use the P/E ratio to identify stocks that might be overvalued or undervalued. Let’s see how:

• If a company has a high P/E ratio

It means the company’s share price is high compared to its earnings and is “overpriced”. Value investors avoid such stocks as they are often driven by speculation and carry higher risk. They see such stocks as "value traps" and believe they could lose value quickly if market sentiment changes.

• If a company has a low P/E ratio

This indicates that a stock is “undervalued” and its market price is lower relative to its earnings. Value investors see this as an opportunity to buy stocks at a discount to their intrinsic value and hold them until their price rises. It is worth mentioning that this strategy relies on patience, as realising gains often requires holding these investments over a longer period.

Calculation of a "good" P/E ratio depends on various factors, such as:

• Market conditions
• Industry averages, and
• The specific industry in which a company operates.

To make a meaningful evaluation using the P/E ratio, investors should compare a company's ratio with those of similar companies within the same industry. For example, if Company A has a P/E ratio of 40 and Company B, with similar characteristics, has a ratio of 10, it means that investors are paying significantly more for each unit of earnings in Company A compared to Company B. Hence, Company B might be a better value investment.

Be aware that high P/E ratios generally indicate that a stock is overpriced. A very low P/E ratio shows poor company performance or underlying issues. Additionally, it is always advised not to rely solely on the P/E ratio. To gain a comprehensive understanding of a company’s profitability, investors should also use other financial metrics, like:

• Discounted cash flow (DCF)
• Weighted average cost of capital (WACC)
• Price-to-book ratio