Understanding PE (Price-to-Earnings) Ratio
The PE Ratio measures the relationship between the company's current stock price and EPS (Earnings Per Share). A PE Ratio indicates how many times investors pay money to get 1 rupee of return. It is one of the important parameters to evaluate whether a company's stock price is overvalued or undervalued.
The PE ratio is the most popular and well-known valuation metric used by many investors to analyze whether a stock is overvalued or undervalued. It indicates how much investors are willing to pay for a stock's current price to earn one rupee.
The formula to derive PE Ratio
Current Price -
It is the most recent selling price of stocks. The current price indicates the current value of the stocks, and it is also known as the market value.
Earnings Per Share (EPS) -
EPS is a measure of the company's profits available for the shareholders on a per share basis and calculated by dividing the Net Income by the Weighted Share Outstanding. EPS is found in the company's Income Statement.
Example of PE Ratio:
Aurobindo Pharma Company's current share price is Rs. 687, and EPS (Earnings Per Share) is Rs.91.05.
The value as per the formula (PE Ratio = Current Price / EPS) is calculated as (687 / 91.05) = 7.55
The PE ratio is the most popular and well-known valuation metric used by many investors to analyze whether a stock is overvalued or undervalued.
This metric indicates how much investors are paying for the company's stock to earn one rupee.
Investors should consider the point while analyzing that the PE ratio does not always guarantee future results, and the EPS number remains the same while the stock price fluctuates daily.
While looking at the PE ratio, the following points should also take into consideration:
A low PE ratio indicates that the company's stock is undervalued, and a high ratio indicates that the stock is overvalued. It is assumed that a company with a PE ratio of 10 is cheaper than a company with a PE ratio of 12. But the lower PE ratio is always not good. It can be due to other circumstances.
Price to Earnings is a commonly used & versatile financial analysis tool that is helpful in identifying value and growth stocks. This metric indicates how much investors are paying for the company's stock to earn one rupee. When analysing, investors should keep in mind that the PE ratio does not always predict future performance and that the EPS number remains constant despite daily price fluctuations in the stock.
It is good if the PE ratio of the particular company decreases over time, but only if its EPS is increasing. And inverse to this, if the PE ratio is decreasing but its EPS is also decreasing, then it is not good.
When a PE ratio is negative, it means a company has negative earnings or is losing money. Even the most established companies go through tough times, which may be brought on by environmental factors beyond the company's control. However, businesses that consistently display a negative PE ratio are not making enough money and run the risk of going out of business.
It's possible that a poor PE is not reported. For quarters where a company reported a loss, the EPS may instead be reported as "not applicable". Investors should be aware of the risks involved when purchasing stock in a company with a negative PE ratio because they are purchasing shares of an unprofitable business.
There are two types of PE ratio:
Trailing PE -
Trailing PE is calculated as the Current Price divided by TTM (Trailing Twelve Months) EPS. This metric is easy to calculate because companies declare the financial results, including EPS, each quarter.
Forward PE -
Forward PE uses the current price and forecasted earnings of the next four quarters for calculation
How to use PE Ratio effectively
A low PE ratio is considered good, but you have to check that the stock is genuinely low or if it is due to other factors.
Compare the PE ratios of companies that operate in the same industry. Comparing consumer companies with cyclic companies doesn't make any sense. Cyclic companies' PE ratio is generally lower than non-cyclic companies'. Cyclical companies are volatile and follow trends in the economy. Non-cyclic or defensive companies like the FMCG industry companies' stocks surpass the market during an economic slowdown.
By doing relative valuation of companies in the same industry will give a better understanding of whether the stock is overvalued or undervalued.
Although PE is the most commonly used valuation parameter, we still have to check other fundamental ratios like EPS
, Trailing PE
, Forward PE
, Price to Book Ratio
, Price to Sales
, Net Margin
, Earnings Yield
A low PE ratio can be due to:
A company is genuinely undervalued.
The growth of the company is slow or negative.
The company may have a high debt burden.
It could be due to investors' losing confidence.
Few people know about the company's stock.
A high PE ratio can be due to:
Many investors have an interest in that stock.
The company is becoming very bullish or growing continuously.
It could be due to future projections.
Striking stock price and fall in earnings.
||Screener at TSR
|| Strong Bullish
|12 to 15
|15 to 18
|| Mild Bullish
|18 to 21
|21 to 24
|| Mild Bearish
|24 to 27
|| Strong Bearish