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The Price Earnings Ratio (PE Ratio) is the relationship between a company’s share price and earnings per share (EPS). It gives an idea of what the market is willing to pay for company’s earnings.

This article covers the following:

  1. How does PE Ratio work?
  2. How to calculate PE Ratio?
  3. What does PE Ratio tell about a stock?
  4. What are the issues involved in PE Ratio?
  5. Conclusion

 

1. How does Price Earnings Ratio work?

Earnings are important when valuing a company’s stock because investors want to know how profitable a company is and how profitable it will be in the future. Moreover, if the growth and level of earnings of the company remain constant, 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 use this ratio as it provides them a better sense of the value of the company and helps them in analyzing how much they should pay for a stock based on its current earnings.

2. How to Calculate Price Earnings Ratio? 

Investors try to find out the basic worth of an equity share before making an investment. They analyze it from various aspects of risk, returns, cash flows, and corporate governance. Amongst other valuation techniques, P/E Ratio happens to be an important tool used to study the intrinsic attractiveness of an equity share. Another name given to P/E Ratio is “earnings multiple” or “price multiple”.

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

 

Price Earnings Ratio

 

Suppose the current market price of the stock of ABC Ltd. is Rs. 90 and its Earning per share are Rs. 9. The Price Earning Ratio of ABC Ltd. will be calculated as follows:

P/E = 90 /9 = 10

Now, it can be seen that P/E ratio of ABC Ltd is 10 times which means that investors are willing to pay Rs.10 for every rupee of earnings.

3. What does Price Earnings Ratio tell about a Stock?

The P/E ratio varies from industry to industry and therefore, should either be compared with its peers having parallel business activity and of similar size or with its historical P/E to evaluate whether a stock is undervalued or overvalued. Traditionally there are certain sectors like diamonds, fertilizers or sectors that are very recurrent and command a low P/E ratio. There are certain sectors like FMCG, Pharma, IT that normally have a higher P/E. The analysis of High and low P/E is given as under:

a. High P/E

Companies with high Price Earnings Ratio are often considered to be growth stocks. It means that investors have higher expectations for future earnings growth and are willing to pay more for them as it indicates a positive future performance. However, the disadvantage of high P/E is that growth stocks are often unpredictable, and this puts a lot of pressure on companies to do more to justify their higher valuation. Therefore, investing in growth stocks will more likely to be a risky investment. Also, in some cases, it can be interpreted as an overpriced stock also.

 

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b. Low P/E

Companies with low Price Earnings Ratio are often considered to be undervalued stocks. It means they are undervalued because the price of their stock is relatively low. A company with a low P/E ratio is usually an indication of poor current as well as future performance. This could prove to be a poor investment. This lower pricing of stock attracts investors to buy their stock before the market corrects it. And when it does, investors make a profit because of the higher stock price.

c. Justified P/E

The justified P/E ratio above 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, the company is undervalued and purchasing the stock will result in profits, if the alpha is closed.

4. What are the issues involved in Price Earnings Ratio?

Even though P/E Ratio is a pretty useful and popular tool in the valuation of stocks, you cannot rely on it as standalone criteria. You need to use it with other valuation techniques to arrive at a correct picture. P/E Ratio suffers from the following issues:

a. The calculation of P/E Ratio makes use of only the earnings and market price of an equity share. It doesn’t look into the debt aspect of the company. There are companies which are highly-leveraged and can be considered as risky investments. However, a high P/E Ratio of such companies will not bring forth this aspect.

b. P/E ratio assumes that the earnings will remain constant in the near future. If the company has a P/E Ratio of 15, it means that the company will continue to provide you Rs 15 on every rupee it earns. However, earnings are dependent on a lot of other things and are volatile.

c. Ideally, an investor needs to invest in a company which keeps generating cash flows throughout its life and at an increasing rate. P/E Ratio doesn’t indicate whether the company’s cash flows are going to increase or decrease in the years to come. Hence, it leaves ambiguity as regards direction of growth.

d. It is assumed that a company having a lower P/E ratio of 10 is cheaper than a company having P/E ratio of 12.  However, you don’t get any information about the quality of earnings of the company. If the company which is trading cheap has a poor quality of earnings, then it can’t be an ideal investment.

5. Conclusion

Whether P/E ratio is considered high or low, depends from sector to sector. For example, IT, telecom sector companies have a higher P/E ratio compared to other sector companies like manufacturing, textile etc. P/E ratio is also dependent on external factors, for instance, a merger and acquisition announced by the company will increase the P/E ratio. So it is important to analyze the background of the company considering all factors before one decides to invest.

 

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