Introduction
PE ratio – Price-to-earning ratio is a metric in the ratio analysis to value the ratio of the share price of the stock to its earnings per share (EPS). The ratio is also popularly known as price multiple or earning multiples.
As the name suggests, in the Price-to-earning ratio, PE ratio, ‘P’ stands for the current price prevailing at the market of a share, and ‘E’ stands for earnings per share. This ratio helps to understand the company’s worth in the market and prospectus growth based on its share price relative to earnings per share. It also helps to understand the growth of the company on its own as compared to its previous records.
How to calculate the PE ratio?
The formula to calculate the PE ratio is,
PE ratio = Market value per share/Earning per share
Earning per share is calculated as,
EPS = (Net income – Preferred dividends) / Weighted average shares outstanding
Illustration
To take an example,
If the EPS of a company is Rs. 1.5…and the current price prevailing at the market is Rs. 30 per share.
Then,
PE ratio = Current Market Price/EPS
= 30/1.5
= 20
This means an investor is willing to pay 20 times per Re 1 to buy that company’s share and the company has the potential to grow in the coming future.
What is an ideal PE ratio?
In the PE ratio, the company understands its prospectus growth and future appreciation. An ideal PE ratio helps make investment decisions from the investor’s point of view.
There’s no exact rule to justify an ideal PE ratio, but on average, a ratio between 20-25 is considered favorable. A ratio exceeding this range is considered unfavourable and poor.
In cases where the company expects the growth of its share price to be much higher than its earnings, the ratio is high.
If the ratio is high, it means the stock is overvalued, or the investors are expecting higher future growth rates. However, the share price is likely to fall in the future.
Investing in a company with a high PE ratio can be risky.
If the share price falls faster than its earnings, the ratio is low. In this case, the stock is undervalued and it’s cheaper.
Investors can expect a growth in its share price in the future. Companies with low PE ratios and strong fundamentals are profitable for investment purposes.
Types of PE ratio
There exist two types of PE ratio that is,
• Trailing PE ratio
• Forward PE ratio
1. Trailing PE Ratio
The trailing PE ratio is the ratio determined by dividing the current market price of the share by the total EPS over the past 12 months. This is considered as an accurate calculation of the earnings and provides an objective view of the growth and performance of the company.
This ratio shows how well the company has performed in the past year. It not only shows the performance of the company but also helps the investor to make future investment decisions.
2. Forward PE ratio
As the name suggests we calculate the forward PE ratio is calculated by taking the earnings estimates of the next 12 months into consideration. It indicates how well the company is performing and is expected to perform shortly.
Investors use this ratio to assess the growth of the company in the future for their investment decisions. Although the company can manipulate its earnings to show growth when its quarterly gains are announced, it bars a limitation to the method.
Apart from these, there are two more variations of the Price-to-earning Ratio,
• Absolute PE ratio
• Relative PE ratio
1. Absolute PE ratio
In absolute PE ratio, the ratio is calculated by dividing the current market price by the earnings per share for a specific period. This is one of the most widely used PE ratios in the industry.
However, in this case, the absolute PE ratio cannot be calculated by comparing two different sectors or industries, which limits its use.
2. Relative PE ratio
Relative PE ratio overcomes the limitation of Absolute PE ratio by taking over the past PEs of a relevant period, say 5 years or 10 years. It is calculated by dividing the PE ratio of the company by the average PE ratio of its industry or sector.
This helps to measure whether the company’s valuation is high or low as compared to other companies in the same industry or sectors.
Limitations of the PE ratio
- PE ratio only takes the current market price and earnings per share into consideration, ignoring the other important elements such as risk profile, debts, and other financial factors.
- PE ratio is useful during a company valuation as well. However, a limitation of this method is, that different sectors have different ideal PE ratios and a single range could not provide justice to determine the ideal decision. A PE ratio for an IT sector company cannot be compared to an FMCG sector company.
- The ratio does not provide an indicator of the annual performance of the company accurately as it does not consider factors such as the country’s economic condition, competition, management, political scenario, etc..
- Relying on the PE ratio entirely to make investment decisions is not a wise choice because investors have other considerable factors as well.
Conclusion
The price-to-earnings ratio is a popular choice for investors as well as the company peers. It is a great metric for stock valuation and to understand the growth of the company. However, it can be inconsistent sometimes due to external factors. Now that we have an understanding of the PE ratio and its calculation, investing decisions can be a little bit easier.
FAQ
- What is the PE ratio?
– The price-to-earnings ratio is, a ratio calculated by dividing the current share price by the earnings per share of a company. - What is a good PE ratio?
– Generally, a low PE ratio is better than a high PE ratio. The average PE ratio falls between 20 to 25. - What is the significance of the PE ratio?
– The PE ratio not only identifies whether the company’s stocks are overvalued or undervalued but also helps the investors make better investment decisions.