The most common statistic for evaluating a company’s valuation is the price to earning ratio or P/E ratio. This valuation ratio aids in understanding the firm’s financial health in comparison to its competitors and industry, in addition to indicating if the company is undervalued or overpriced. To learn about the P/E ratio’s varieties, applications, and restrictions, read on.
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Defining P/E Ratio
The price to earning ratio (P/E ratio) measures the connection between a company’s stock price and earnings per share (EPS). It is a well-liked ratio that provides investors with a clearer understanding of the industry’s worth.
- The P/E ratio displays market expectations and represents the cost per unit of total earnings (or future earnings, as the case may be).
- Although shareholders want to know how lucrative a company is and will be in the future, earnings are crucial for evaluating a firm’s shares.
- In addition, the P/E may be viewed as the time it will take the firm to recoup the price paid for each share assuming the company doesn’t expand and its present level of profits stays constant.
Calculating P/E Ratio
Price to Earning Ratio = Price Per Share % Earning per Share
Calculating the market value of each corporate share:
The NSE and other stock exchanges where the corporation is listed provide access to this information. This number is always changing.
Finding or assessing the company’s earnings per share:
The organisation’s profit or revenues may be discovered on websites. Whether they are past or projected. Alternatively, one may get the P/E ratio by dividing the company’s net profit (profit after taxes) by the total amount of outstanding common shares.
Calculating the P/E ratio and using the P/E formula:
To calculate the P/E multiple, divide the stock price (as established in Step 1) by the earnings per share (as determined in Step 2). In addition, the analyst can assess a firm’s P/E value about other businesses and previous P/E multiples.
For example, stock A is not inherently more costly if it is selling at ₹300 while stock B is at ₹200. From a value standpoint, the P/E ratio can assist us in deciding which of the two is less expensive. Even if Stock A has a greater absolute price than Stock B, if the sector’s average P/E is 15, Stock A is more affordable since one pays less for every Re.1 in current earnings. Stock B, however, has a larger ratio than both its rival and the industry. This might imply that investors would anticipate future profit growth that is higher than the market average.
Types of P/E Ratio
Trailing Twelve Months (TTM)
It is calculated by dividing the most recent share price by the last four quarterly EPS. Because businesses report their financial results, including EPS, every quarter, TTM P/E is simple to compute.
Forward P/E
Forward P/E is calculated by dividing the current share price by the anticipated EPS for the following four quarters. Since estimating sales, margins, P&L, and EPS is involved in calculating future P/E, skill is required. Based on information from corporate management and their research, research analysts project future earnings and P/E ratios.
As share prices already reduce past earnings (EPS), forward earnings are more important than TTM P/E because they may predict future changes in stock price. Past earnings (EPS) are already discounted in share prices. Having said that, TTM P/E time series analysis can also offer insightful information about whether a stock price is about to boil. When compared to prior P/Es, TTM P/E can reveal the market as a whole or if the market index is excessively high or low.
Relative P/E
Relative P/E contrasts the present absolute P/E with a variety of prior absolute P/Es throughout a pertinent period, such as the last ten years. The highest value of the range is typically used to compare the present P/E value to relative P/E. For instance, a stock’s relative P/E will be 0.9 if its greatest P/E ratio during the previous ten years was 30, while it is presently trading at a P/E of 27.
Understanding of P/E Ratio
Reconsider the idea that profits solely come from investing in growth stocks. Even with a stellar company showing consistent earnings growth, profitability is unlikely if shares were purchased at a high price. It is crucial to acquire a company at a fair price, necessitating the use of valuation measures. One widely used approach is the P/E ratio, indicating the costliness of a company’s stock. In simple terms, it represents the amount paid for each earned Rupee by the company.
Limitations of P/E Ratio
- A ratio serves as a quick tool to estimate a corporation’s stock price. However, the P/E ratio has limitations, especially when comparing businesses across industries. P/E ratios can vary significantly across different industries.
- Inexpensive stocks often have reasons for their low P/E ratios, warranting further investigation.
- The P/E ratio uses earnings per share, which can be misleading.
- Companies with negative free cash flow may declare positive earnings due to various accounting techniques.
- Relying on a single statistic like the P/E ratio is insufficient to determine a stock’s investment potential.
Significance of P/E Ratio for Investors
Few indicators in the stock market have witnessed as significant fluctuations in popularity as the P/E ratio, credited to the legendary investor Benjamin Graham. Utilised to assess an investment’s attractiveness, P/E ratios compare a company’s share price to its earnings. The trailing P/E ratio divides the current share price by the aggregate earnings per share (EPS) over the last 12 months, while the forward P/E ratio considers expected future profits per share. These ratios provide valuable insights into the investment’s quality.
Conclusion
The P/E ratio serves as a crucial tool for investors, offering valuable insights into a company’s stock price in relation to its earnings. However, it is essential to recognise the limitations of this ratio, especially when comparing businesses across different industries. Investors should use the P/E ratio as one of many factors in their comprehensive analysis, considering other metrics and industry-specific dynamics for a more informed investment decision.
