P/E ratio formula
= Market price per share ÷ Earnings per share
= Rs. 100 ÷ Rs. 5
= 20
This means that shareholders are willing to pay 20 times the earnings for each share of the company. A high P/E ratio indicates that the share price is high compared to the company’s earnings, hinting at a possible overvaluation. Conversely, a low Price-to-earnings ratio can mean the company’s shares are undervalued.
P/E ratio - Calculation and example
Based on its definition, you can use the formula shown below to compute the price-to-earnings ratio of any stock:
P/E ratio = Current market price of a share / Earnings per share
Let’s discuss an example to better understand the meaning ofthe PE ratio in stock market and how it is calculated. Say the market price of a share is currently Rs. 100, and the company’s EPS is Rs. 5. The P/E ratio in this case will be computed as follows.
Types of price to earnings (PE) ratio
There are two types of P/E ratios: trailing and forward. Trailing P/E uses past earnings per share (EPS), while forward P/E is based on projected future EPS, typically estimated by company management or analysts:
1. Trailing P/E ratio
The trailing Price earnings ratio is one of the used metrics by investors, as it is based on a company's past earnings over a specific period. This approach offers a more accurate and objective assessment of the company's financial performance.
2. Forward P/E Ratio
Price to Earnings ratio is calculated by dividing a company's stock price by its projected earnings per share (EPS) based on future earnings guidance. Since this calculation relies on estimated future earnings, it is often referred to as the estimated P/E ratio in stock market. Investors use the forward price-to-earnings ratio to evaluate a company's expected future performance and projected growth rate.
Absolute P/E ratio and Relative P/E ratio
Absolute P/E is the current price-to-earnings ratio. Relative P/E compares it to historical averages or benchmarks to assess valuation in context:
1. Absolute P/E ratio
The Absolute P/E ratio, often referred to simply as the P/E ratio, is the straightforward calculation of a company’s current stock price divided by its earnings per share. This ratio gives investors a snapshot of how much they are paying for each rupee of the company's earnings.
Formula:
Absolute P/E ratio = Current stock price/Earnings per Share (EPS)
Uses and interpretation:
- Valuation benchmark: It is used as a benchmark to determine whether a stock is overvalued, undervalued, or fairly valued compared to its earnings.
- Comparative measure: Investors often compare a company’s absolute P/E ratio with the industry average, market average, or historical P/E ratios of the same company.
- Growth and expectations: A higher P/E ratio may indicate that investors expect higher earnings growth in the future, while a lower P/E might suggest the opposite or signal that the stock is undervalued.
2. Relative P/E ratio
The Relative P/E ratio compares a company’s current price-to-earnings ratio to a benchmark like its historical average, industry peers, or the broader market. This comparison helps investors evaluate whether a stock is trading at a premium or discount relative to its usual or expected valuation. By providing a contextual framework, the Relative P/E ratio allows for more informed decisions about whether the stock may be overvalued or undervalued based on its position against relevant reference points.
Formula:
Relative P/E Ratio = (Current P/E Ratio)/(Benchmark P/E)
Uses and interpretation:
- Historical comparison: By comparing the current P/E ratio with historical averages, investors can assess whether the stock is trading at a higher or lower valuation than usual.
- Industry and market comparison: Comparing the P/E ratio to industry or market averages helps investors understand how the company is valued relative to its peers or the overall market.
- Contextual valuation: The relative P/E ratio provides a more nuanced view of valuation, accounting for broader market conditions and industry trends.
Example: If a company has a current P/E ratio of 20, the historical average P/E ratio is 15, the industry average is 18, and the overall market average is 25:
- Relative to historical average: 2015=1.331520=1.33 (The current P/E is 33% higher than its historical average)
- Relative to industry average: 2018=1.111820=1.11 (The current P/E is 11% higher than the industry average)
- Relative to market average: 2025=0.802520=0.80 (The current P/E is 20% lower than the market average)
Understanding both Absolute and Relative P/E ratios allows investors to make more informed decisions by not only assessing the intrinsic value of a stock but also placing that valuation in the broader context of historical performance, industry standards, and overall market conditions.
What is a good PE ratio?
A good P/E ratio depends on context, not just its value. With the market average between 20–25, a higher P/E may signal overvaluation, while a lower one may suggest value important to recognise that the "goodness" of a P/E ratio is contingent upon various factors, including prevailing market conditions, industry averages, and the specific nature of the business.
To make informed comparisons, investors should assess how a company's P/E ratio stacks up against peers within the same industry, with similar characteristics and growth trajectories. For example, a company with a P/E ratio of 40 is trading at a significantly higher premium compared to a peer with a ratio of 10. This suggests that investors are willing to pay more for each rupee of earnings in the former company.
While high P/E ratios may signal potential overvaluation, low ratios could indicate suboptimal performance or underlying issues. Therefore, relying solely on the P/E ratio for investment decisions can be risky. To gain a more comprehensive understanding, investors should consider additional financial metrics such as discounted cash flow and weighted average cost of capital.
Using P/E ratios to determine investment strategies
The P/E ratio can be instrumental in formulating long-term investment strategies. If the P/E ratio is high, it typically indicates that investors are currently paying a premium for the company's shares, even though its earnings are low. Over the long term, price corrections may occur, bringing the company’s share price lower and closer to its intrinsic value.
On the other hand, if the P/E ratio of a company is currently on the lower end, it means that the market may be undervaluing the company — even though its earnings are high. Over time, when investors realise the company's true worth, they may drive the price up, leading to long-term capital appreciation.
Sector-wise PE ratios: Comparing Companies Using the P/E Ratio
There is no absolute cut-off for determining a good P/E ratio from a bad one. Instead, a more effective strategy is to compare the price-to-earnings ratios of two different companies within the same industry or sector to get more clarity about their valuation. If the price-to-earnings ratio for a company is higher than the sectoral average, it may be indicative of overvaluation (and vice versa).
Limitations of the P/E ratio
Despite the many insights you can get with the P/E ratio in the share market, this metric has its limitations. They include the following:
- The ratio does not factor in a company’s debts.
- It does not give you insights about the company’s cash flow.
- You do not learn any material information about the quality of the company’s earnings.
- It is not very effective for comparing companies in different sectors or industries.
Relationship between P/E ratio and value investing
Value investors prioritise the intrinsic value of a company's underlying assets over its current market price. The Price-to-Earnings (P/E) ratio is a crucial tool in this approach, helping to identify potential mispricings.
A high P/E ratio suggests that a company's share price is significantly higher relative to its earnings, potentially indicating an overvalued stock. Value investors generally avoid such stocks, as they may be subject to speculative bubbles and prone to significant price corrections.
A below-average P/E ratio might suggest that a stock is undervalued, potentially offering a good buying opportunity. However, it’s important to compare P/E ratios within the same industry, as valuation standards can vary significantly across different sectors. Contextual analysis ensures more accurate investment decisions.
Value investing typically requires a long-term investment horizon to fully realise its potential returns.
Conclusion
The bottom line is that a company’s P/E ratio is not a foolproof indicator of its valuation. It is best to combine the P/E ratio in the share market with other indicators and ratios like the price-to-sales ratio, price-to-book ratio, debt-to-equity ratio, and dividend yield. This will give you a comprehensive overview of the company’s future prospects.
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