5 min read
You might be confused about what is PE ratio, but here you will get to know it perfectly. The Price-to-Earnings (P/E) ratio is a crucial concept in the stock market as it helps investors determine whether a stock is undervalued, overvalued, or fairly valued, aiding in making informed investment decisions. Here, you will gain a comprehensive understanding of what is PE ratio, including its meaning, formula, types, a real example, limitations, and benefits. Additionally, you will learn how comparing a company’s P/E ratio to its industry P/E ratio offers further insights. By the end, you will have a clear understanding of what is PE ratio and be one step closer to making informed investment decisions.
What is PE ratio?
The P/E ratio, or Price-to-Earnings ratio, is a financial ratio that is derived from a company’s financial statements, specifically the income statement. It tells about the relationship between a company’s current share price and its earnings per share (EPS). The P/E ratio indicates how much investors are willing to pay for each rupee of the company’s earnings in terms of the stock price. This ratio is crucial for investors as it helps them to evaluate whether a stock is undervalued, overvalued, or fairly valued.
The P/E ratio is calculated by dividing the current market value of a stock by the earnings per share (EPS). It represents how many years an investor would need to earn back their investment, assuming the company’s earnings stay the same.
The P/E ratio isn’t fixed and can vary because of changes in either the stock price or earnings per share (EPS). When a company’s earnings rise, its EPS goes up, typically leading to a lower P/E ratio. This lower ratio suggests that investors can recover their investment more quickly. Conversely, the P/E ratio is also influenced by fluctuations in the share price, which can shift based on market conditions and investor sentiment. As the share price changes, the P/E ratio adjusts accordingly.
A lower P/E ratio can suggest that a stock is undervalued, which might lead to quicker returns, though it could also indicate underlying issues. In contrast, a higher P/E ratio may imply that a stock is overvalued, but it also reflects strong investor confidence and expectations of significant future growth. The ideal ratio depends on the company’s financial outlook and other key financial metrics.
Formula - Price-to-Earning (P/E) Ratio
The formula for calculating the P/E ratio is:
P/E ratio: Current share price / Earnings per share (EPS)
Where,
The Current share price is the current market value of a single share.
Earnings per share (EPS) is the company’s total net profit divided by the company’s common shares outstanding.
A Real World Example of P/E ratio calculation - Tata Steel
Let’s calculate the Price-to-Earnings (P/E) ratio for Tata Steel as of August 20, 2024.
Share price: 153
Q2 (2023-24)= (6511.16) Cr. , Q3 (2023-24)= 522 Cr. , Q4 (2023-24)= 555 Cr. , Q1 (2024-25)=919 Cr.
Net profit (Earnings)= (4515.16) Cr.
Note: Tata Steel has not issued any preference shares, so no preferred dividends have been paid.
Weighted average shares outstanding= 12,462,467,532
Earnings per share = Net profit – Preferred dividend/ Weighted average shares outstanding
(45,15,16,00,000) / 12,462,467,532 = (3.62)
P/E ratio= Current share price / Earnings per share (EPS)
154 / (3.62) = -42.54
P/E Ratio (TTM) = (42.54)
Note: Note: A negative P/E ratio signifies that the company is experiencing losses or has negative earnings.
What is a good P/E ratio?
The Price-to-Earnings (P/E) ratio is a popular metric used to gauge the valuation of a company’s stock. It compares a company’s current share price with its earnings per share (EPS), showing how much investors are willing to pay for each rupee of earnings.
Determining what constitutes a good P/E ratio involves considering various factors, including:
- Industry benchmark: Comparing a company’s P/E ratio to the industry average helps determine if the stock is fairly priced compared to similar companies.
- Economic Conditions: The overall economy affects P/E ratios. When the economy is strong and growing, P/E ratios might be higher because investors are more confident and willing to pay more for stocks. In a downturn, P/E ratios often drop as earnings fall and investor confidence weakens.
- Historical Context: Evaluating a company’s P/E ratio within its historical range can provide important insights. By comparing the current P/E ratio to historical averages, investors can assess whether the stock is trading at a premium or discount compared to its past performance.
- Growth Expectations: A higher P/E ratio can be reasonable if investors expect the company to grow significantly in the future. Growth stocks usually have higher P/E ratios because people are willing to pay more now for the expected future earnings. On the other hand, a lower P/E ratio might indicate that investors expect slower growth or that the stock is undervalued.
Note: Investors should not rely solely on the P/E ratio to make an investment decision; rather, they should consider a range of factors including the company’s earnings growth potential, financial health, industry conditions, and broader economic trends. It’s also essential to consider other valuation measures, like the price-to-book ratio, price-to-sales ratio, and dividend yield, to gain a fuller understanding of how appealing the investment is.
Types of P/E ratio
- Trailing Twelve Months (TTM) P/E: The Trailing Twelve Months (TTM) P/E ratio is the most common type of P/E ratio, calculated using the company’s earnings from the most recent 12 months.
Formula: Current share price / Earnings per share (EPS) for the trailing twelve months
- Forward P/E: The Forward P/E ratio is calculated using the company’s estimated earnings for the next twelve months. This ratio looks at future earnings to provide insight into the company’s expected growth and current valuation.
Formula: Current share price / Projected EPS for the next 12 months
Absolute & Relative P/E ratio
- Absolute P/E ratio: The Absolute P/E ratio is the standard P/E ratio calculated using either the earnings from the Trailing Twelve Months (TTM) or the projected earnings for the next twelve months.
- Relative P/E ratio: The Relative P/E ratio compares a company’s P/E ratio to the P/E ratios of other companies in the same industry or to its own highest P/E ratio from a previous relevant time period.
Benefits and limitations of the P/E ratio
Benefits
- Simple: The P/E ratio is very easy to understand and calculate, you just need to divide the current share price by the earnings per share to calculate the P/E ratio.
- Informed investment decision: It assists investors in determining if a stock is overpriced, underpriced, or reasonably priced based on its earnings.
- Comparison: The P/E ratio is used by investors to compare companies within the same industry or sector.
Limitations
- Ignore debt: The P/E ratio does not consider the company’s debt. Two companies might have the same P/E ratio, but if one has a lot of debt and the other doesn’t then their financial health could be very different.
- No guarantee: The P/E ratio might suggest that a company will grow in the future, but it doesn’t guarantee that will happen.
- Dependent on earnings: The P/E ratio is based on earnings, which can be inconsistent. For a company having higher earnings this year, it might be possible that its earnings might drop next year due to unexpected problems, making the ratio less reliable.
What is the Industry P/E ratio?
The industry P/E ratio reflects the average Price-to-Earnings (P/E) ratio across all companies within a particular industry or sector. It serves as a benchmark for comparing an individual company against its industry peers, helping investors determine if a stock is undervalued, overvalued, or fairly valued relative to the industry average.
Example: If the average P/E ratio for the Iron & Steel industry is 25 and JSW Steel has a P/E ratio of 30, the company might be considered more expensive compared to its peers. Conversely, if JSW Steel’s P/E ratio is 20, it could be viewed as undervalued relative to the industry average.
Conclusion
What is PE ratio? – the Price-to-Earnings (P/E) ratio is an essential financial metric that highlights the relationship between a company’s stock price and its earnings per share. The P/E ratio essentially shows how much investors are ready to pay for each rupee of a company’s earnings relative to its stock price. It helps investors assess whether a stock is undervalued, overvalued, or fairly valued.
The P/E ratio is determined by dividing the current price of the stock by the earnings per share. Our discussion, including the practical example of Tata Steel, has demonstrated how to calculate and interpret this ratio using real-world data. This hands-on example illustrated the practical application of the P/E ratio and provided a clearer understanding of its implications.
For well-informed investment decisions, it’s crucial to integrate the P/E ratio with other valuation methods and conduct thorough research. This thorough approach allows investors to navigate the complexities of stock market investing with improved understanding and confidence.
By now, you should have a clear understanding of what is PE ratio and how it works. with this knowledge, you can make better investment decisions and improve your portfolio for better financial results.
FAQs
Q1. What is PE ratio and how can it be used to compare companies within the same sector?
A1. The Price-to-Earnings (P/E) ratio is a financial metric derived from a company’s financial statements, calculated by dividing the current stock price by the earnings per share (EPS). Investors use the P/E ratio to assess whether a stock is undervalued, overvalued, or fairly valued. By calculating the average P/E ratio for the sector, investors can establish a benchmark for evaluating individual companies against their peers.
Q2. How does the P/E ratio assist investors in assessing a company’s financial health?
A2. The P/E ratio helps investors evaluate a company’s financial health by showing how much they have to pay for each rupee of earnings. A high P/E ratio indicates that a stock may be overvalued or that investors expect substantial growth, while a low P/E ratio suggests that the stock could be undervalued or reflects potential underlying issues within the company. Comparing a company’s P/E ratio with those of other firms provides insight into whether the stock is fairly priced.
Q3. What is the meaning of negative P/E ratio?
A3. A negative P/E ratio arises when a company reports losses rather than profits. Since the P/E ratio involves dividing by earnings per share, negative earnings lead to a negative ratio.
Q4. Does the P/E ratio remain constant over time?
A4. No, the P/E ratio does not remain constant. It can fluctuate due to changes in the company’s earnings, stock price, or both.
Q5. Where can we find the financial data needed to calculate the P/E ratio of a company?
A5. You can find the financial data needed to calculate a company’s P/E ratio in several places, including the company’s financial statements, financial news websites, brokerage apps, stock exchanges, and financial books.
Q6. What is P/E Ratio Used For in Investment Decisions?
A6. The P/E ratio is used to determine if a company’s stock price is undervalued, overvalued, or fairly valued. By understanding why a stock is priced this way, investors can make more informed investment decisions.
Q7. What is PE Ratio Role in Investment Decision-Making?
A7. The P/E ratio influences investment decision-making by offering insights into a stock’s valuation, helping investors decide whether to buy, hold, or sell based on how the stock’s price aligns with its earnings.
Q8. What is PE Ratio of Reliance Industries Ltd.?
A8. As of August 2024, Reliance Industries Ltd. has a P/E ratio of 29.76, while the industry average stands at 19.12. This suggests that Reliance’s stock may be overvalued, likely driven by investor confidence in the company’s growth potential due to its strong performance.
Q9. What is PE Ratio of 20 indicates?
A9. A P/E ratio of 20 means investors are paying 20 times the company’s earnings per share for each stock. This suggests that, at the current earnings level, it would take about 20 years for investors to get back their money if earnings stay the same.
Also Read
