An Overview of Shares and Ratio
The price-earnings ratio, also known as the P/E ratio, is the ratio of a company’s share price to the company’s earnings per share. The price-earning ratio determines whether a company is overvalued or undervalued. It is one of the most popular measures of valuing stock. PE ratio indicates whether a stock at its current price is expensive or cheap. The P/E ratio can also reveal how a share’s valuation compares to its industry or most popular benchmarks like the S&P 500 and Dow Jones Industrial Average.
What is the PE Ratio?
Price-earning ratio relates a company’s stock price to its earnings per share. This ratio is also known as the price multiple or the earnings multiple. Investors and analysts use these ratios to determine the respective value of a company’s share. The company can also use these ratios to compare against its previous records or with similar companies in the markets.
What is the PE Ratio in Shares?
PE ratio helps investors to measure the market value of a respective share compared to an organisation’s earnings. If earnings are expected to increase in the future, the share price goes up. The PE ratio becomes high when the share price grows faster than earnings. A high PE ratio indicates that a stock is expensive and its price may fall in the future. On the other hand, a low PE ratio indicates that a stock is cheap and its price may rise in the future.
PE Ratio Formula
One should divide the current stock price by the earnings per share to calculate the PE ratio.
P/E ratio = Market value per share / Earnings Per Share
Or
P/E ratio = Market Capitalization / Total Net Earnings
Example
A company’s stock price closed at Rs. 120.55. The company’s earnings per share were Rs. 3.75. Calculate the PE ratio.
Ans: PE ratio = Rs. 120.55/ Rs. 3.75 = 32.15
Important Points to Remember About PE Ratio
The P/E ratio varies across the firms and is helpful compared to peers with similar business activities.
A high PE ratio means that investors have higher expectations and are willing to pay more, which indicates a positive performance.
A low PE ratio means weak current as well as future performance. This can lead to bad investment decisions.
A justified PE ratio means that the company is undervalued but purchasing a stock may result in some profits.
A negative PE ratio means the company loses money and may go bankrupt.
Types of P/E Ratio
Forward P/E Ratio - This ratio is calculated by dividing the prices of a single unit of share of a company and the estimated earnings of a company. This ratio is also known as the estimated P/E ratio, as this ratio is based on the company's future earnings.
Trailing P/E Ratio - This ratio is the most commonly used by investors. The company's past earnings over a period are considered in this type of ratio. The trailing P/E ratio provides an accurate and objective view of a company’s performance.
Solved Example
The P/E ratio of Nestle is provided along with the P/E ratio of similar companies in the industry.
Nestle’s price to earnings ratio is 26.8x and the industry’s price-to-earnings ratio is 42.8x. A good price to earnings ratio is one that is lower than the price-to-earnings ratio of similar firms of the whole industry.
Conclusion
In this article, we discussed the PE ratio. Price-earning ratio is considered a great metric for stock and index valuation. PE ratio depends on the sector to which a company belongs. For example, the IT and telecom sector companies have higher P/E ratios. The main advantage of this ratio is it is easy to calculate. PE ratio is also dependent on external factors. For example, when a company announces its merger and acquisition, it will increase its PE ratio.
FAQs on Price-Earning Ratio
1. What are some limitations of the PE ratio?
The following are some limitations of the PE ratio:
PE ratio only considers earnings and the market price of an equity share. This ratio does not consider the debt aspect of the company.
This ratio assumes that the earnings will remain constant shortly.
This ratio does not indicate whether a company's cash flow will increase or decrease in future years.
This ratio assumes a company with a lower PE ratio of 10 is cheaper than a company with a PE ratio of 12. It does not consider the quality of the earnings of the company.
2. What are the absolute P/E ratio and relative P/E ratio?
Absolute P/E Ratio - It refers to the traditional P/E ratio. In this ratio, the current share price of a company is divided by either past earnings or future earnings.
Relative P/E Ratio - In this, the absolute ratio of a company is compared against a benchmark P/E ratio or the past price to the earnings of respective companies. This ratio is used by investors to determine how well a company is performing with its past ratios or benchmark ratios.
3. What is the PEG ratio?
The price-earnings-to-growth ratio is a share’s price-to-earnings ratio divided by the growth rate of its earnings for a specified time. This ratio determines a share’s value while factoring in the company’s expected earnings growth. This ratio provides a more complete picture than the standard price-earning ratio.
The PEG ratio for a company may differ significantly from one source to another, depending on which growth estimate is used in the calculation. To calculate this ratio, an investor or analyst needs the P/E ratio of the company.
