Fundamental analysis is crucial to identify long-term investment opportunities in the stock market. It involves evaluating various financial ratios to identify if a stock is overvalued or undervalued. One such ratio that is pivotal in determining a stock's valuation is the P/E ratio.
The full form of the P/E ratio is the price-to-earnings ratio. In this article, we will delve into what the P/E ratio means, how to calculate it, the different types of this ratio, its uses, and its limitations.
What is the P/E ratio in the share market?
The P/E ratio in the stock market is a metric that is used to compare the market price of a company’s stock with its earnings per share (EPS). The ‘P’ in the numerator represents the current market price, while the ‘E’ in the denominator represents the EPS. This ratio is commonly used in fundamental analysis to identify if a company’s shares are valued more or less than their true intrinsic value.
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:
Price-to-Earnings Ratio = Market Price per Share ÷ Earnings per Share
Let’s discuss an example to better understand the meaning of the P/E ratio 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.
P/E ratio:
= 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 P/E ratio can mean the company’s shares are undervalued.
Types of PE ratio
Two types of P/E ratios are outlined below based on the data used to compare the share price and its earnings.
- Trailing P/E ratio
The trailing P/E ratio uses historical data and relies on the company’s past performance to determine its valuation. Here, the current market price of the company’s shares is divided by its total EPS over the past 12 months.
On the upside, this type of P/E ratio uses accurate or already available data. But on the flip side, the prices may be outdated since past performance does not guarantee results in the future.
- Forward P/E Ratio
As the name indicates, the forward P/E ratio relies on projected or estimated earnings. It compares the current market price of a company’s shares with its estimated earnings for the next 12 months.
The main limitation of the forward P/E ratio is that the projections may be inaccurate. If a company underestimates its future earnings, it may lead to a higher P/E ratio. And if the future earnings are overestimated, the P/E ratio may be lower, making the shares seem undervalued.
Relationship between forward and trailing P/E ratios
The trailing and forward P/E ratios can be used in conjunction with one another to get a more comprehensive picture of a company’s valuation. If you’ve been tracking the company’s forward P/E ratio for the past year, you can compare the projected ratio with its actual trailing P/E ratio. This will help you estimate how accurate the company’s future projections are.
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.
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.
