WHAT IS P/E RATIO?
PE Ratio is perhaps the most popular financial statistic in the stock market discussions. The P/E Ratio i.e. Price to Earnings Ratio is the relationship between a company's stock price and its EPS (Earning Per Share). It is used to find out the value of a company, whether it is undervalued or overvalued. Financial analysts and investors generally use this to determine a company’s growth and the relative amount of share for the company to company comparison. A high PE ratio points that the investors are expecting high growth rates in the future or the company is overvalued. In crux, it can be considered as a summary measure that primarily reflects the following factors: risk characteristics, growth prospects, shareholder orientation, degree of liquidity, and corporate image.
P/E RATIO FORMULA
P/E = Market Capitalization/Total Net Earnings
Or
P/E = Stock Price Per Stock/EPS
FORMULA EXPLANATION
The general formula to calculate the current PE ratio takes into account the EPS(Earnings per share) and current stock price. If we talk about the calculation of EPS, it is ascertained by dividing the earning from the last 12 months by the weighted average share outstanding,
WHAT DOES P/E RATIO TELLS ABOUT A STOCK?
The Price to Earnings ratio differs across industries and therefore, should either be compared with its historical P/E to evaluate whether a stock is undervalued or overvalued or its peers having a similar business activity (of identical size). Conventionally, there are specific sectors such as fertilizers, diamonds, and so on, that command a low P/E ratio. There are specific other sectors such as Pharma, FMCG, and IT that generally have a higher P/E ratio. The analysis of high and low P/E is as below:
1. High P/E
This indicates that the company is considered to be growth-oriented because investors are ready to pay more as they see a positive future performance and expect high returns from the company. But this also makes the stock highly unpredictable and volatile, and this, in turn, puts pressure on companies to justify the same making them a risky option. The high P/E ratio of a company could also be interpreted as the company being overvalued.
Value investors generally avoid investing in companies having high P/E ratio in comparison to their competitors & historical ratios.
2. Low P/E
This indicates that the company’s shares are undervalued which means that the price of their stock is low relative to its earnings. A company with a low P/E ratio can be interpreted as an indication of weak expectations of the future as well as current performance by investors. It could also be interpreted as the company is undervalued and its stock price is low compared to its fundamentals. These companies/stocks can be called as value stocks. This lower pricing of stock attracts individuals to buy their shares before the markets start correcting and the stock moves toward its intrinsic value. And when it starts correcting, investors make a profit because of the higher stock price.
TYPES of PE RATIO
There are 2 types of P/E Ratio which individuals take into consideration – forward P/E ratio and trailing P/E ratio. Both of these ratios depend on the nature of earnings, as elaborated below:
- Forward Price to Earnings Ratio:
This is also termed as the estimated PE ratio because it takes into consideration the future earnings of a company. To calculate this ratio, the price per unit of stock is divided by the estimated earnings of a company derived from its future earning projections. Most often this ratio is used by investors to assess and analyze the company’s future performance and growth.
2. Trailing Price to Earnings Ratio:
This ratio relies on past performance. It is very popular among investors because it gives a more objective & accurate view of the company as it is based on the past performance of the company. To calculate this, the current price per unit of stock is divided by the total EPS earnings over the past year.
Also Read: What is Sharpe Ratio - Formula, Limitation & Comparison with Information Ratio
RELATIONSHIP B/W VALUE INVESTING AND P/E RATIO
To understand the relationship between the two, first, we have to understand the concept of value investing. It tells us that while operating in the stock market, an investor should consider the intrinsic value of the company over its market price of the share. This is because the market price is derived from market forces and other factors that may not tell the true potential or value of the company.
Now the market value of the share can be either overvalued or undervalued, and this we can easily determine by the use of PE ratio. Now let us understand what will a value investor do when:
1. PE ratio is higher than industry average or historical average:
High PE indicates that the share market price is overvalued. More than often, a value investor won’t be interested in these kinds of stocks as it indicates high speculation, low potential, and it also signifies that the company is exposed to systematic risks that may arise from inefficient management.
2. PE ratio is lower than the industry average or historical average:
A low PE ratio indicates that the stock market price is undervalued. This does attract value investor and they see it as a positive case because they can go forward with buying these stocks at a relatively low price and when these companies grow, they can heavily benefit from them.
The value investing concept can only reap benefits when the stocks are held for a long tenure as it takes time for an undervalued company to work upon its growth potential and grow multi-folds to reach near to its intrinsic value.
ABSOLUTE AND RELATIVE PRICE TO EARNINGS RATIO
- Absolute P/E Ratio:
It refers to the conventional P/E ratio, wherein the current stock price of a company is divided by either future or past earnings.
- Relative P/E Ratio:
In the calculation of relative P/E ratios, the absolute PE ratio of a company is compared against a benchmark ratio or ratio of its peer companies.
These are used to ascertain how well a company has performed in relation to the industry standards which are determined by its benchmark or past trends. For instance, if the relative ratio of an entity is 115% when it is put in comparison with a benchmark PE ratio, this signifies that the entity’s absolute PE ratio is more than the benchmark and it has outperformed the benchmark performance i.e. the industry standard during that specific tenure. An exactly opposite conclusion can be drawn when the relative ratio is less than 100% as it will imply that the entity has underperformed.
LIMITATIONS OF P/E RATIO
Like any other fundamental made and designed to inform investors on whether or not a stock is worth the price, the P/E ratio comes with a few important limitations/demerits that are necessary to take into account, as investors may often be led to believe that there is one metric that will provide a full-fledged insight into an investment decision, which is never the case. Companies that aren't profitable, and therefore have no earnings, or negative EPS, pose a challenge when it comes to computing their P/E.
One predominant limitation of using this ratio emerges when comparing P/E ratios of companies in different sectors. Growth rates and valuation of companies may often vary between sectors due to both the differing timelines during which companies earn that money and differing ways companies earn money.
As such, an investor should only use P/E as a comparative tool when considering companies in the same sector, as this kind of comparison is the only kind that will yield productive information. Comparing the P/E ratios of a pharma company and an IT company, for instance, may lead investors to believe that one among them is clearly the better investment, but this is not a reliable assumption.
Frequently Asked Questions
- What is P/E Ratio?
P/E ratio is a valuation formula. It is used to compare the valuations of a company with its peers or industry average numbers. P/E ratio shows the relation between the stock price and the earnings of the company. It can be used to determine whether the company’s stock is undervalued or overvalued.
- What is the formula to calculate the P/E ratio?
There are two different formulas to calculate the P/E ratio which are:
- P/E ratio = Market Capitalization/Total Net Earnings
or
- P/E ratio = Stock Price Per Stock/Earning Per Share
- What does the P/E ratio tell about a stock?
If the company has a high P/E ratio, then it can conclude to be growth-oriented stock as investors are ready to pay more for the stock and if the P/E ratio is low, it can be concluded that the stock is undervalued as the price is relatively low to its earnings. Low P/E can indicate weak expectations for the future as well.
- What are the different types of P/E ratios?
There are 2 types of P/E ratios that are taken into consideration. Both the ratios depend on the nature of the earnings. Types of P/E ratio are:
- Forward P/E Ratio
- Trailing P/E Ratio
- What is a good P/E ratio?
A good P/E ratio depends on the industry average P/E ratio. As such, there is no definition for a good P/E ratio. Some industries have a higher P/E ratio and some have a lower P/E ratio. Even if the P/E ratio of a stock is high but it is lower than the industry average, then also we can say that it is good and vice versa.
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