What is PE Ratio in Share Market?

Hindi: हिंदी में पढ़ने के लिए यहाँ क्लिक करें।

Ever wondered how great investors predict the value of a company or identify a multi-bagger stock? There are multiple parameters that help them come to a conclusion before they start investing. One of the major criteria that they look at before investing in a particular stock is the P/E ratio of the company. Now, let’s define the P/E ratio in the simplest terms possible.

What Is the PE Ratio?

In India, the price-to-earnings (P/E) ratio is a popular metric used to assess a stock’s valuation or the broader market. Here, the P stands for “Current Market Price (CMP) of a single share”, and E stands for “Earnings Per Share (EPS).” The P/E ratio helps to understand the company’s worth today and the growth anticipated based on how its share prices are relative to its earnings per share. Let’s explain with an example:

PE calculation and example:

• Ravi & Vinod started their own clothing business. Both of them invested a starting capital of ₹20,000 in the business.
• Each of them gets 5000 shares of ₹12 each.
• The capital structure:
  • Total Capital: ₹40,000
  • No of shares: 10,000
  • Shareholder: 2

Now, you have a successful business for 1 year by generating a profit of ₹30,000. As a result, each owner gets 50% of the profit, which comes up to ₹15,000. So, the earnings per share (EPS) calculation will be:

EPS = Earnings / No. of shares

= ₹15,000 / 10,000

= ₹1.5

This will give both partners an idea about the earnings of each 5000 shares. Now that they know that they are earning a profit, Ravi & Vinod tell their success stories to their friends. Now, one of the friends gets excited and decides to invest in this profitable business. So, he comes to the partners and decides to buy 1000 shares at a cost of ₹15/share ( he cannot buy at ₹12 as the business is successful).

As a result, the friend added a premium of ₹3 over the base rate of ₹12 per share.

Then, the P/E ratio will be:

P/E = Price / EPS

= ₹15/1.5

=10

This means the friend is happy to pay 10 times more to buy the shares and get an opportunity to earn an equal proportion as Ravi & Vinod. As P/E is also called a value calculator, in this story, it is 10x. So here, the new shareholder is willing to pay 10x.

Now the question arises: What is the ideal PE ratio?

If a P/E ratio is high, investors deduce that the stock is overvalued and sell the shares or refrain from buying. In case the shares are undervalued, investors purchase them at lower rates to claim profits when the unrealised value is tapped. There is no ideal P/E as such, but as per historical data, the ideal P/E value ranges between 20-25.

Remember that a high P/E stock can always gain momentum in the market. However, a question that is often asked is, “How high is better”? The answers depend more on investors. A P/E will never be high if more people are not thinking about these stocks. This is one of the main reasons why some stocks are overvalued or sold at a premium. So, one should always remember the management quality before investing for good returns.

Types of P/E Ratio

• Absolute P/E Ratio: The absolute P/E ratio in the stock market is calculated by dividing the current market price of a stock by its earnings per share (EPS) for the most recent 12-month period. This ratio indicates how much investors are willing to pay for each unit of earnings generated by the company. Generally, a higher absolute P/E ratio indicates that investors are willing to pay a premium for the stock’s earnings, while a lower P/E ratio suggests that the stock may be undervalued.
• Relative P/E Ratio: The relative P/E ratio, also known as the P/E ratio compared to the market or sector average, is calculated by dividing the absolute P/E ratio of a stock by the average P/E ratio of its peer group or the broader market. This ratio indicates whether a stock is overvalued or undervalued compared to its peers or the overall market. A relative P/E ratio above 1 indicates that the stock is trading at a premium compared to its peers or the market, while a ratio below 1 suggests that the stock is undervalued.
• Trailing Price to Earnings: The trailing P/E depends upon the past performance of a company. It is calculated by dividing the recent stock price by the total EPS earnings over the past year. It is one of the most reliable and popular PE metrics, using actual data on the company’s profits. Prudent investors take the trailing PE as the basis of most of their financial decisions, as future earnings estimates could be unreliable. However, investors must remember that a company’s past performance does not necessarily guarantee its future behaviour.
• Forward Price-To-Earnings: The forward (or driving) P/E utilises estimated future income as opposed to trailing earnings figures. It is also known as the estimated cost of earnings. This indicator is valuable for providing a base of comparison between the current income and future income. It gives a clearer image of what and how the company’s profits will pan out.

Relationship Between P/E Ratio and Value Investing

The price-to-earnings (P/E) ratio is an essential metric in value investing, which is an investment strategy that involves buying stocks that are undervalued by the market. Value investors believe that the market can sometimes misprice stocks and that by identifying companies with strong fundamentals trading at a discount to their intrinsic value, they can generate superior returns.

The P/E ratio in the stock market is used by value investors as a tool to assess whether a stock is overvalued or undervalued by the market. Stocks with a low P/E ratio relative to their peers or the broader market may be considered undervalued and potentially good investment opportunities. This is because a low P/E ratio in the stock market suggests that the market is not fully valuing the company’s earnings potential and that the stock may be trading at a discount to its intrinsic value.

Using PE Ratios To Determine Investment Strategies

PE ratios help in share selection. A low trailing P/E of a promising company’s stock could be an excellent investment. While a high P/E usually indicates that the price is overvalued compared to the company’s earnings. 

However, if the economy is booming, a high ratio does not mean the shares are overpriced, as the overall market sentiment is positive. So, while P/E ratios are used to select stocks, careful estimation and relative assessment of the total ratio reap profits in the long run.

Also, did you know that some companies have a Negative P/E ratio? And why do they? A negative P/E ratio happens when a company has negative earnings or loses money. If a company’s earnings per share is lower than zero, then the stock can have a negative P/E ratio. Any company (big/small) can have a negative P/E ratio. However, if any company has a consistent negative P/E ratio then it is not generating enough money.

Sectorwise PE Ratios 

PE ratios could vary from industry to industry. A possible way of determining if a sector or industry is overpriced is when the average PE ratio of all the organisations in that sector or industry has values much more than the historical P/E average.

While investing, investors gauge the market value of the industry, in general, to understand how a sector is faring and then compare it to the individual company’s stock price to make a calculated judgement.

Limitations

• Industry Variability: Different industries have different PE norms. A high PE in one industry might be normal, while it’s considered low in another. Comparing PE ratios across industries can be misleading.
• Lack of Context: PE doesn’t consider external factors like economic conditions, competition, management quality, and industry trends. It’s just one piece of the puzzle.
• Volatility: Stock prices and earnings can fluctuate, making PE ratios inconsistent. A temporary earnings dip or surge can distort the ratio.

Conclusion

The PE ratio is an essential tool to understand the company and market behaviour at any given point in time. Investors and companies rely on this ratio to make financial decisions and effectively value their stocks based on the share market Value and earnings to date or future earnings. PE ratio, though a comprehensive metric to evaluate a specific company’s worth, can be inconsistent at times due to fluctuating stock prices or earnings.

Now that we know what PE in the stock market is, a well-researched and informed approach should be followed when investing. So once you are done with your research, take your first step in investing by opening a Demat account.

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