PE Ratio – Price to Earnings Ratio

The price-to-earnings ratio, also known as the P/E ratio, is one of the most popular valuation metrics for stocks used by many investors. It provides an indication of whether a stock is overvalued or undervalued at its current market price. In this article, let's understand what the P/E ratio is, how it is calculated, and its formula. 

What is the P/E Ratio

The P/E ratio stands for price-to-earnings ratio, which calculates how much investors are willing to pay for every rupee of earnings. Stock earnings (EPS) can either be distributed to shareholders as dividends or reinvested in the business to grow revenues and EPS in the future, leading to capital appreciation. 

The PE ratio is the price investors are willing to pay for Rs 1 of EPS of the company. If earnings are expected to grow in the future, the share price increases, and vice versa. If the share price grows significantly faster than the earnings growth, the PE ratio becomes high. 

Conversely, if the share price falls much faster than earnings, the PE ratio becomes low. A high PE ratio indicates that a stock is expensive and may decline in price in the future. A low PE ratio suggests that a stock is cheap and may increase in price in the future.

How Does the P/E Ratio Work

The P/E Ratio helps investors gauge the market value of a share compared to the company’s earnings. In simple terms, you get to know how much the market is willing to pay for a stock based on the company’s past and future earnings.

Example: 

A high P/E Ratio indicates that a stock price is high compared to a company's earnings and may be overvalued. 

Similarly, a low P/E Ratio indicates that the share price is low compared to the company's earnings and is undervalued. 

However, you must determine if the share price is low because of the company’s underperformance over time.

Why the P/E Ratio is Important

Earnings are substantial when valuing a company’s stock, as investors want to know how profitable and valuable it will be in the future. Moreover, if the company's growth and earnings level remain constant, then the P/E can be interpreted as the number of years it will take for the company to pay back the amount paid for the share. 

Investors often look at this ratio, as it gives a good sense of the company's value and helps them analyse how much they should pay for a stock based on its current earnings. If the company's growth and earnings level remain constant, then the P/E can be interpreted as the number of years it will take for the company to pay back the amount paid for the share. 

Investors often look at this ratio, as it gives a good sense of the company's value and helps them analyse how much they should pay for a stock based on its current earnings.

How to Calculate the Price to Earnings Ratio

Investors usually like to know the underlying worth of an equity share before investing. They analyse it from various aspects such as risk, returns, cash flows, and corporate governance.

Amongst other valuation techniques, the P/E ratio is an essential tool used to study a share's intrinsic attractiveness. Other names given to P/E Ratio include ‘earnings multiple’ or ‘price multiple’. P/E Ratio is calculated by dividing the market price of a share by the earnings per share.

P/E Ratio is calculated by dividing the market price of a share by the earnings per share. 

Example:

CMP of XYZ Ltd. is: Rs 90, 

Earnings per share: Rs 9

PE = Current Market Price / Earnings Per Share

P/E = 90 / 9 = 10

Now, XYZ Ltd.'s P/E ratio is 10, which means that investors are willing to pay Rs 10 for every rupee of company earnings.

What Does the PE Ratio Tell About a Stock

The P/E ratio varies across industries and should, therefore, be compared with its peers having similar business activity (of similar size) or with its historical P/E to evaluate whether a stock is undervalued or overvalued. 

Traditionally, specific sectors, such as diamonds, fertilisers, and so on, command a low P/E ratio. Other sectors, such as FMCG, Pharma, and IT, generally have a higher P/E. The analysis of high and low P/E is as follows.

High P/E

Consider picking stocks of companies with high price-to-earnings ratios. This indicates that investors have higher expectations for future earnings growth and are willing to pay more for them, which is a positive sign of future performance. 

However, the disadvantage of high P/E is that growth stocks are often unpredictable, which puts a lot of pressure on companies to do more to justify their higher valuation. Therefore, investing in growth stocks will likely be a risky investment. 

Low P/E

Stocks of companies with a low price-to-earnings ratio are often considered undervalued. A low P/E ratio usually indicates weak current and future performance, making it a poor investment.

However, you must buy the shares of the company only if the fundamentals are strong. You must buy stocks of undervalued companies with strong fundamentals to make profits over time. 

Justified P/E

The justified P/E ratio is calculated independently of the standard P/E. In other words, the two ratios should produce two different results. If the P/E is lower than the justified P/E ratio, then it means that the company is undervalued and purchasing that stock may result in profits over time.

Negative P/E

You may find a company that is losing money or has a negative earnings and P/E ratio. For instance, established companies may experience periods of negative cash flow due to factors beyond their control. However, you must not invest in companies with consistent negative P/E ratios as they may go bankrupt. You have companies not reporting EPS for some quarters. In this way, they may avoid showing a negative P/E. 

What are the Issues Involved in the Price Earnings Ratio

Even though the P/E ratio is a valuable and popular tool in the valuation of stocks, you cannot rely on it as a standalone criterion. It would help if you used it with other valuation techniques to arrive at a correct picture. The P/E ratio is affected by the following parameters: 

• The calculation of the P/E Ratio accounts only for the earnings and market price of an equity share. It doesn’t consider the company's debt. Some companies are highly leveraged and can be considered risky investments. However, a high P/E ratio of such companies will not reflect this. 
• The P/E ratio assumes that earnings will remain constant in the short term. However, earnings are dependent on many other factors and can be volatile. 
• Ideally, an investor needs to invest in a company that keeps generating cash flows throughout its lifecycle, at an increasing rate. P/E ratio doesn’t indicate whether a company’s cash flow is going to increase or decrease in the years to come. Hence, it leaves room for ambiguity as regards the direction of growth. 
• It is assumed that a company having a lower P/E ratio of 10 is cheaper than a company having a P/E ratio of 12. However, you don’t get any information about the quality of the company's earnings. If the company that is trading cheap has a low quality of earnings, then it can’t be an ideal investment.

Conclusion

Whether a P/E ratio is considered to be high or low depends on the sector. For instance, the IT and telecom sector companies have a higher P/E ratio compared to companies from other industries like manufacturing, textiles, etc. P/E ratio is also dependent on external factors such as a merger or acquisition announced by a company, which will increase the P/E ratio. So, it is indispensable to examine the backdrop of the company, considering all constituents, before investing.