P/E ratio is short for the ratio of a company’s share price to its per-share earnings. As the name implies, to calculate the P/E, you simply take the current stock price of a company and divide by its earnings per share (EPS). A stocks PE ratio also known as its price multiple. Generally speaking, investors will pay more for a company that offers better returns and growth prospects, and a higher P/E ratio reflects this.
P/E ratio gives Market Value per share. P/E ratio helps to find quality bargains and one can decide if the current stock prices are making sense or not.PE ratio is one of the most widely used tools for stock selection. PE ratio shows the sum of money you are ready to pay for each rupee worth of the earnings of the company.
The Interpretation of PE ratio is heavily dependent on comparison of the company with its peers. Also PE that is considered very high in certain sectors can be considered very low in other sectors. Companies in IT and telecom sectors have higher PE ratio than the companies in manufacturing or textile sectors.
Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E. However, occasionally the EPS figure comes from estimated earnings expected over the next four quarters. This is known as the leading or trailing P/E. A third variation that is also sometimes seen uses the EPS of the past two quarters and estimates of the next two quarters.
Companies that aren’t profitable, and consequently have a negative EPS, pose a challenge when it comes to calculating their P/E. Historically, the average P/E ratio in the market has been around 15-25. This fluctuates significantly depending on economic conditions. The P/E can also vary widely between different companies and industries.
Other primary limitation of using P/E ratios emerges when comparing P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due both to the differing ways companies earn money and to the differing timelines during which companies earn that money.
KEY POINTS:
- Generally a high P/E ratio means that investors are anticipating higher growth in the future.
- The average market P/E ratio is 20-25 times earnings.
- The P/E ratio can use estimated earnings to get the forward looking P/E ratio.
- Companies that are losing money do not have a P/E ratio.
- If you compare PE figures for the same business over a period of time, or the figures of similar companies at the same point in time, or even the PE ratio of one company to that of the market as a whole, you can theoretically assess when a stock has become overvalued or undervalued in the eyes of the market.
- Consider the state of overall economy when sizing up a stock with an uncharacteristically high P/E ratio, since this may be the result of “good times” within the market as a whole, rather than a result of that individual company’s improved performance.
- Don’t simply expect that a stock with a low P/E ratio will rebound to its industry norm, without the hard data to support that expectation.
