Price to Earnings Ratio (P/E Ratio)

Introduction

In mutual fund investment, there are many terminology that you should get comfortable with for becoming a better-informed investor. Here we’ll discuss one of those terminologies such as Price to Earnings Ratio (P/E Ratio).

What are P/E Ratio?

The Price to Earnings Ratio (P/E Ratio), also known as the Price to Earnings Multiple, compares a company’s current share price to its earnings per share (EPS). Widely used as a valuation tool for stocks, it helps determine if a stock is overvalued or undervalued at its current market price. Investors utilize this ratio to gauge the stock’s relative affordability and make informed investment decisions.

The P/E Ratio is calculated by dividing the current share price by the earnings per share (EPS), typically based on earnings from the past 12 months or one year. It serves as a key metric for analysts and investors, offering insights into the company’s performance and market perception, often referred to as an earnings multiple.

How P/E Ratio get Calculated?

The Price to Earnings Ratio (P/E Ratio) is calculated by dividing the current market price of a share by the earnings per share (EPS). This metric is widely used by analysts and investors worldwide to assess the value of a company’s stock. The P/E Ratio indicates how much investors are willing to pay for each unit of the company’s earnings. For example, if a company has a P/E Ratio of 20, investors are willing to pay Rs. 20 for Re. 1 of its current earnings.

A high P/E Ratio may suggest that the company is overvalued or experiencing significant growth prospects. It could also indicate anticipation of increased future revenue, leading to a surge in current stock prices due to speculation by analysts and investors. Conversely, a low P/E Ratio may indicate undervaluation of stocks, possibly due to market risks or expectations of poor future performance. In some cases, a low P/E Ratio may signify declining stock prices due to anticipated future challenges faced by the company.

Types of Price to Earnings Ratio

There are two main types of P/E ratios that investors consider:

Forward P/E Ratio: Also known as the estimated P/E Ratio, this metric is calculated by dividing the price of a single unit of a company’s stock by the estimated earnings derived from its future earnings guidance. It provides insight into how a company is expected to perform in the future and its estimated growth rate. Investors use the forward P/E Ratio to gauge future prospects and potential changes in earnings.
Trailing P/E Ratio: This is the most commonly used metric by investors, calculated based on a company’s past performance over a period, typically the past four quarters or twelve months. It offers an objective view of the company’s historical performance. The trailing P/E Ratio is calculated by dividing the current share price by the earnings per share of the last year. A higher trailing P/E ratio indicates bullish investor sentiment, while a lower ratio may suggest either bearish sentiment or undervaluation.

Absolute P/E Ratio versus Relative P/E Ratio

There are two other variations of the P/E ratio:

Absolute P/E Ratio: The absolute P/E ratio, also known simply as the P/E ratio, is calculated by dividing the current market price of a company’s stock by its earnings per share (EPS) for a specific period. While commonly used, it has limitations due to different share price ranges across companies or sectors, making it challenging to use as a benchmark for comparison. For example, the PE ratio of the automobile sector may differ from that of the FMCG sector.
Relative P/E Ratio: The relative P/E ratio compares a company’s P/E ratio to that of other companies in the same industry, market, or benchmark P/E. It helps measure whether a company’s valuation is high or low compared to its peers. This ratio is calculated by dividing the company’s P/E ratio by the average P/E ratio of its industry or sector. It enables investors to assess how well a company is performing relative to its industry peers or benchmark ratios.

Relationship between P/E Ratio and Value Investing

The relationship between the P/E ratio and value investing is fundamental, as the P/E ratio serves as a key metric for assessing the attractiveness of a stock through the lens of value investing principles. Here’s how the P/E ratio intersects with these principles:

Identifying Undervalued Stocks: Value investors seek stocks trading at a discount to their intrinsic value. A low P/E ratio relative to peers or historical averages may indicate that a stock is undervalued compared to its earnings potential.
Earnings Yield: The P/E ratio can be interpreted as the inverse of the earnings yield. A higher earnings yield, indicated by a lower P/E ratio, may make a stock more appealing to value investors, as it implies a higher return on investment relative to the stock price.
Long-Term Perspective: Value investors focus on the long-term fundamentals of a company. The P/E ratio helps identify stocks with sustainable long-term growth potential, aligning with the value investor’s emphasis on intrinsic value and future earnings prospects.
Contrarian Approach: Value investors often adopt a contrarian approach, seeking opportunities where market sentiment has led to undervaluation. Low P/E ratios may signal such undervaluation, as market pessimism may overshadow a company’s true earnings potential.
Qualitative Analysis: While the P/E ratio provides valuable quantitative insights, value investors also consider qualitative factors such as the quality of management, competitive advantages, and industry trends. These qualitative factors complement the quantitative analysis provided by the P/E ratio, enabling investors to make more informed investment decisions.

What is a good P/E Ratio?

A good P/E ratio is not a fixed number but varies depending on factors such as current market conditions, industry norms, and the growth phase of the company. Investors should compare a company’s P/E ratio to others in the same industry with similar characteristics to gauge its relative performance.

For instance, let’s consider Company A with a P/E ratio of 40 and Company B, a similar company in the same industry, with a ratio of 10. Shareholders of Company B are essentially paying less for each unit of earnings compared to those of Company A. In such cases, investing in Company B might be more lucrative.

High P/E ratios may signal the risk of overvalued stocks, while low ratios could indicate underperformance due to internal issues. However, there’s no one-size-fits-all P/E ratio for investors to rely on. Instead, they should consider additional indicators such as discounted cash flow and the weighted average cost of capital for a more comprehensive assessment of a company’s profitability.

As a general guideline, a lower P/E ratio is often preferred, while a higher ratio may raise concerns. The average P/E ratio typically falls between 20 to 25, with ratios below this range considered favourable and those exceeding it viewed less favourably.

Conclusion

While the P/E ratio provides valuable insights into a stock’s valuation, it should not be the sole determinant for investment decisions. Factors such as growth prospects, industry trends, management quality, and economic conditions should also be taken into account to assess a stock’s attractiveness comprehensively.

Disclaimer: The views expressed here are of the author and do not reflect those of Dhanvantree. Mutual funds are subject to market risks, please read the scheme documents carefully before investing.