Price is often the first thing investors and traders notice when looking at a stock. A company’s stock price demonstrates its current financial health, earnings and growth prospects. Investors often check a company’s stock price against its intrinsic value to determine if it is over-valued or under-valued relative to its current market price.
The Price-to-Earnings ratio is one of the most commonly used financial metrics to understand the valuation of a stock. The PE ratio tells investors whether a stock is cheap or expensive, helping them make an informed decision. In the following sections, we will cover everything you need to learn about price-to-earnings, including PE ratio meaning, importance, interpretation, types and more.
What Does the PE Ratio Mean?
The price-to-earnings or PE ratio compares a company’s share price against its earnings per share or EPS. EPS is a company’s net income divided by the total number of outstanding shares, a metric that shows a company’s profitability for its shareholders.
The PE ratio definition shows the relative value of a company’s shares. This is useful for comparing the valuation of a company against the overall market and competitors as well as against its past trends. This ratio reveals the number of rupees that investors are currently willing to pay for every ₹1 in earnings generated by a company.
Why Do Investors Look at the PE Ratio?
The PE ratio is the most widely accepted metric for stock valuation, especially when used with a benchmark or industry peers. This is because it’s a relatively simple metric that any investor can use to understand the valuation of a company and if the price paid for its stock is too low or high.
As the PE ratio is calculated using earnings, it gives a good idea of how profitable a stock is. It also shows the market’s expectations based on how much investors are willing to pay per stock. If a company does not grow further, its price-to-earnings multiple will show how many years it will take for this company to pay back the amount paid for each share.
How to Interpret the PE Ratio?
The price-to-earnings ratio is one of the most widely used financial metrics to assess a stock’s relative valuation. Generally speaking, if the share price is much lower relative to the earnings generated by a company, it’s undervalued, i.e., it is a cheap stock. On the other hand, if the PE ratio of a stock is very high compared to its earnings, it’s an expensive stock.
However, the PE ratio by itself gives little useful information to investors. One needs to compare the PE ratio of a company to its historical PE trends, competitors in the same industry or the broader market by taking the price-to-earnings multiple of an index.
For long-term valuation trends, investors can also look at a company’s PE 10 or PE 20, which shows the average PE for the previous 10 or 20 years, respectively.
What is a Good PE Ratio for a Stock?
Usually, investors prefer a company with a lower PE ratio as it generates more returns for every rupee a company earns. A higher PE ratio generally means the stock is more expensive than the returns it can generate for investors. However, in practice, this simplified approach does not work.
You cannot use a single price-to-earnings ratio for all stocks, as different sectors and industries tend to have different PE ratios. Instead, you should compare the price-to-earnings value of similar companies within the same industry. In addition, you should check the historical PE values to find out whether a stock is trading near its high or low ranges to assess whether it is a good time to buy or sell.
A PE ratio of 20-25 is considered average, with lower PE ratios preferred by value investors and higher PE ratios preferred by growth investors. Different industries have different average PE ratios. A PE ratio of 10 is normal for the utility sector but too low for companies in the technology sector.
Sectors such as agriculture, insurance, oil and gas, construction and telecommunication, etc., tend to have PE ratios below 20. On the other hand, sectors such as banking, asset management, auto manufacturing, etc., usually have PE ratios above 30.
What are the Different Categories of PE Ratio?
Based on the type of insights, there are four types of price-to-earnings ratios:
- Absolute PE: The most widely used price-to-earnings ratio, the absolute ratio, is calculated by dividing the current stock price by trailing EPS or forward PE. You can also add the EPS of the previous two quarters to the forward PE of the next two quarters to get the absolute PE value. It’s best for comparing stocks in the same sector.
- Relative PE: The relative PE can be used to compare stocks across different sectors as it compares the absolute PE to a benchmark or a series of historical PE ratios. The relative PE compares the current PE ratio to the highest value of the time period under consideration (say 30 years).
- Forward PE: This type of PE ratio gives investors insights into how the company is expected to earn. Also called the estimated PE ratio, it is calculated as the current stock price divided by the projected EPS for the next 12 months. Future earnings are forecasted by analysing historical trends, company financials and various internal and external factors to calculate the PE ratio.
- Trailing PE: The trailing twelve-month PE, or TTM PE, is the most common PE ratio used by investors. It is calculated by dividing the current share price by the EPS of the previous four quarters from the company’s quarterly results. Its advantage is that it provides accurate estimates and provide insights into past performance.
How to Calculate the P/E Ratio?
The price-to-earnings ratio is calculated by dividing the current market price of each share by the EPS (earnings per share). Here is the PE ratio formula:
PE Ratio = Market value per share/ earnings per share
You can find the stock price by looking at the stock ticker symbol on any financial website or the respective stock exchange website. To find out the EPS, divide the company’s net profits by its prevailing share price. You can also find it in the company’s quarterly earnings report.
Let’s say that you want to invest in a company called ABC Manufacturers Pvt. Ltd. (NSE: ABC). Suppose the current stock price is ₹230 while its EPS is ₹45/share. If you use the PE ratio formula, the calculations will be:
PE ratio = ₹ (230 / 45) = ₹5.11, which is relatively low for a manufacturing company.
How Can You Use the PE Ratio to Select Stocks?
Follow the given steps to compare stocks using the PE ratio and make informed investment decisions:
Step 1: Compare against the Benchmark:
Compare the PE ratio with the broader market by checking the PE ratio of Nifty 50 or BSE Sensex. You can also compare against an industry-specific index like Nifty Bank, Nifty IT, BSE Bankex, Nifty Auto, BSE Auto, etc.
Step 2: Compare against Industry Peers:
Next, compare your chosen company’s price-to-earnings ratio with its industry peers. If the valuation is higher than its competitors, the overvaluation must be justified by factors like market share, superior growth prospects, etc.
Step 3: Study the Stock’s Past PE
You need to compare the company’s PE ratio against its historical PE to understand if the stock is trading at its high or low range of prices. For instance, if the company’s PE was 30 over the past five years but it’s trading at 15 now, it may be a good time to invest.
Step 4: Choose Your Investment Strategy
The right PE value depends on your investment strategy, i.e., whether you are engaged in growth or value-style investing. Here’s is what each type of investor should consider:
- Growth Investing: Growth investors invest in stocks with higher-than-normal price-to-earnings ratios as they want to profit from rapid earnings growth. However, the earnings potential of a high PE stock must be justified.
- Value Investing: Value investors prefer undervalued stocks with low PE ratios. They will look for a stock trading at lower prices compared to its fundamentals and invest before the price increases.
Step 5: Assess the Earnings Quality
Two companies within the same industry with similar earnings can trade at different prices due to different perceived values in the eyes of investors. Factors such as competitive advantages, larger market share, consistency in past earnings, and anticipation of new projects can drive up the PE ratio of a stock for justifiable reasons.
As an investor, you should consider all the important aspects of valuation when comparing two or more stocks. Invest only after carrying out a thorough comparison of the fundamentals and key financial metrics of the different companies.
Final Words
The P/E ratio is a simple yet powerful metric that helps investors quickly gauge whether a stock is fairly valued compared to its earnings. While it offers valuable insights when comparing companies across different sectors and markets, it should not be the only factor guiding investment decisions. A more reliable strategy involves combining the P/E ratio with other fundamental indicators such as debt levels, cash flow strength, price-to-book ratio, and price-to-sales ratio for a complete picture of a company’s financial health.
For investors looking to put these insights into action, it’s essential to have the right financial tools in place. Opening a Demat Account, Trading Account, or even a 3-in-1 Account linked to your Savings Account can streamline your investment journey, making it easier to analyze, invest, and manage your portfolio efficiently.
