What is PE (Price to Earning Ratio) in Stock Market? (Beginner’s Guide):
Yes, you read the title correct!
Many of the individual’s that have been the participants of the stock market, majorly don’t know the appropriate use of Price-to-earnings ratio and its definition.
Here, in this article, I am going to discuss the concept of Price-to-earnings ratio in brief by mentioning all the important details about the ration.
Let us first start with the flow by understanding the definition.
What is P/E Ratio?
The price-to-earning (PE) ratio is most commonly used for the selection of stocks.
This ratio helps to discover the value of the company on the basis of the current stock value per share for every rupee of its future earnings.
The price-to-earnings ratio is also known as “the price multiple or the earnings multiple”.
The P/E ratios are majorly used by the investors and the analyst to determine the relative value of a company’s share by making comparison with their peer companies.
It can also be used to compare a company against its own historical record or to make the comparison with the aggregate markets against each other or over time.
The P/E ratio is helpful in finding out the company’s today worth and the growth anticipated on the basis of the shares prices relative to the earnings per share.
Investors make the decision of investing in a company by analyzing its P/E ratio with the industry and with its peer.
Suppose, if the P/E ratio is high it indicates that the stock is overvalued and the investors will decide to sell the shares or hold back from buying the stocks.
Whereas, if the P/E ratio is low then it indicates that the stock is undervalued and the investors gets bullish to buy the stocks as it will be trading at a lower prices and can claim profits when the unrealized value is tapped.
Companies with no earnings or that are losing money do not have a P/E ratio as there is no value to insert in the denominator.
This was all about the introduction and definition part of the P/E ratio.
Now, let’s move forward by understanding its Formula and Calculation:
P/E Formula and Calculation
The analyst and the investors projects the company’s P/E ratio when they want to find out whether the share price is fairly representing the estimated earnings per share.
The Formula and the calculation used for the P/E ratio is mentioned below:
P/E Ratio = Market Value per Share/ Earnings per Share
Earnings per Share can be obtained in two ways:
The first one to the medium of estimation or it is also known as “PE TTM”, where TTM refers as “Trailing 12 months”.
In this method, the company shows the performance in the course of the past 12 months.
The second way of EPS is based on the organization’s profit expectations and this takes into account the best possible way of the company on how it expects its earnings to be in the future.
Now let’s talk about the types of P/E Ratio.
Types of PE ratios
There are mainly two ways of calculating the P/E ratio and they are:
- Trailing Price to Earnings
- Forward Price to Earnings
Trailing Price to Earnings (PE)
The trailing P/E depends upon the past performance of a company by dividing the recent stock price by the total EPS earnings over the past year.
It is one of the most reliable and popular PE metrics as it takes the actual data of the company’s profits.
Wise investors take the trailing PE as the basis of most of their financial decisions as the future earnings estimates could be unreliable.
However, investors must remember that a company’s past performance does not necessarily guarantee its future behavior
Also, the trailing P/E ratio is not reflective of real-time company scenarios.
While trailing P/E ratios include the latest movement of the price of a company’s stock, the earnings used are still the last reported quarterly earnings.
So, while the stock price that moves every few hours might capture the latest updates within the company, the trailing P/E ratio remains more or less constant as the EPS is dated.
For this reason, some investors prefer the forward P/E over the trailing PE.
So now let’s check in brief about Forward P/E.
Forward Price To Earnings
The forward (or driving) P/E utilizes estimated future income as opposed to trailing earnings figures.
It is also known as the estimated cost to earnings.
This indicator is valuable for providing a base of comparison between the current income and future income and gives a clearer image of what and how the company’s profits will pan out.
Though FPE is a reliable measure in assessing the future earnings of a company, FPE has certain limitations.
Organizations can manipulate by underestimating their earnings in an attempt to outperform the estimate PE ratio when the quarterly gains are announced.
Or overestimate P/E to push stock prices higher and miss earnings estimated.
Such estimation causes a stock to be overvalued or undervalued, and investors never realize the expected returns.
Now let’s talk about the relationship between the forward and the trailing P/E ratio.
Relationship between forward and trailing P/E ratio
While both forward and trailing P/E ratios have their own advantages and disadvantages, investors must use them wisely, depending on their overall investment strategy and current portfolio.
If the forward P/E ratio is less than the trailing P/E ratio, it translates that investors expect the earnings of the company to increase and vice versa.
Using PE ratios to determine Investment Strategies:
PE ratios help in the process of stock selection.
A low trailing P/E of a promising company’s stock could be an excellent investment.
While a high P/E usually indicates that the price is overvalued compared to the earnings of the company.
However, several high growth companies have higher P/E ratios, such as technology companies, as the growth potential estimated by investors on such stocks could be higher.
Similarly, if the economy is booming, a high ratio does not mean the shares are overpriced as the overall market sentiment is positive.
So, while P/E ratios are used to select stocks, careful estimation and relative assessment of the total ratio reap profits in the long run.
Comparing Companies Using the P/E ratio
PE ratio can be used to compare the prices of stocks of companies belonging to the same sector, industry, and who are exposed to the same socio-economic factors.
If Company X and Company Y are selling their commodity at Rs.100, the P/E ratio could still be different as it is dependent upon the profits generated and how the stocks have grown for each organization.
The earnings of both companies can differ.
For example, X might have reported revenues of Rs. 40 per share, which means a PE ratio of 2.5, and on the other hand, Y has an earning of Rs. 50 per share, PE ratio is 2. Y is cheaper, and the investor chooses to buy Y’s stocks because the ROI is higher.
Sector-wise PE ratios
PE ratios could vary from industry to industry – what is considered as the benchmark for the automobile sector may be too low for a technology sector company.
A plausible way of determining if a sector or industry is overpriced is when the average PE ratio of all the organizations in that sector or industry have values much more than the historical P/E average.
While investing, stock marketers gauge the market value of the industry, in general, to understand how a sector is faring and then compare it to the individual company’s stock price to make a calculated judgment.
Limitations of P/E ratio
Interpretation of the PE ratio depends upon the comparison of a company alongside its peers and competitors.
It is wise to keep in mind that a particular PE, which is considered high in specific industries, can be very low in others.
For instance, IT players and telecommunication companies have higher PE ratios compared to textile or manufacturing sectors.
Another thing to understand is that whenever there is a significant acquisition by a company, this pushes up its PE.
On the contrary, a lower PE may indicate bad news as it can signify serious issues being faced by the company.
Thorough research is to be done about a company or a sector before taking up a significant investment decision.
PE ratio is not the be-all, and end-all indicator of a company’s annual performance as the performance is subjected to other external factors such as economic conditions, leadership efficiency, operational challenges, competition, and more.
From this article on “What is Price-to-earnings (PE) ratio in Stock Market?” we had provided all the important and detailed information an analyst or the investor should know before evaluating the ratio for making a decision for certain company.
PE ratio is the powerful formula used by the investors and the analyst to make the decision whether they can opt for investment in a particular company or not.
Lastly, I want to conclude the article by stating that this ratio has some subhead pointers that are equally important to know about in brief and while doing the calculation of the ratio make sure that you have analyze the numbers properly in the first place.
“You can also check our article that is on EPS – What is EPS in Stock Market?”
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