1. How Does the pe ratio ( Price Earnings Ratio ) Work?
Earnings are substantial when valuing a company’s stock as investors want to know how profitable a company is and how valuable it will be in the future. Moreover, if the growth and level of earnings of the company 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 value of the company, and helps them analyse how much they should pay for a stock based on its current earnings.
2. How to Calculate the Price 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 happens to be one of the essential tools used to study the intrinsic attractiveness of a share. 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 = 90 /9 = 10
Now, it can be seen that the P/E ratio of ABC Ltd. is ten, 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 across industries and therefore, should either be compared with its peers having a similar business activity (of similar size) or with its historical P/E to evaluate whether a stock is undervalued or overvalued. Traditionally there are specific sectors such as diamonds, fertilisers, and so on, that command a low P/E ratio. There are specific other sectors such as FMCG, Pharma, and IT that generally have a higher P/E. The analysis of high and low P/E as follows:
a. High P/E
Companies with high price-earnings ratios 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 be a risky investment.
b. Low P/E
Companies having a low price-earnings ratio are often considered to have undervalued stocks. This means that the price of their stock is relatively small. A company with a low P/E ratio is usually an indication of a weak 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 markets start correcting. And when it does, investors make a profit because of the higher stock price.
c. Justified P/E
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 will result in profits.
4. What are the Issues Involved in Price Earnings Ratio?
Even though the P/E ratio is a pretty useful 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:
a.The calculation of P/E Ratio accounts only for 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 shortly. However, earnings are dependent on a lot of other things and can be volatile.
c. Ideally, an investor needs to invest in a company which 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.
d. 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 earnings of the company. If the company which is trading cheap has a low quality of earnings, then it can’t be an ideal investment.
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, textile, etc. P/E ratio is also dependent on external factors; a merger and acquisition announced by a company will increase the P/E ratio. So, it is indispensable to examine the backdrop of the company, considering all constituents, before investing.