The Indian stock market includes thousands of stocks, which you can choose to invest to make profits. However, as the stock market is volatile, the stocks you choose may end up falling in price, forcing you to incur heavy losses. Experienced investors ensure that they execute extensive research to analyse the stock and predict its future price direction to avoid losses and earn profits. One way to analyse stocks is through fundamental analysis, which includes comparing stocks using their PE ratios.

If you are a stock market investor, it is important to know about PE ratio as it can help you identify profitable stocks. This blog will help you understand What is PE ratio and how the price-to-earnings ratio can help you invest better. 

• PE ratio is the measurement of a company’s current share price to its earnings per share(EPS).
• A high PE ratio suggests that the investors are willing to pay more for each unit of earnings, and the company may have high growth potential.
• A low PE ratio may indicate that the stock is undervalued or that the company is facing financial challenges. 

The price-to-earnings (PE) ratio is a financial metric that compares a company's current share price to its earnings per share (EPS). It shows how much investors are willing to pay for each unit of earnings. A high PE ratio means that investors are willing to pay more because they believe the company has high growth potential. On the other hand, a low PE ratio means that the stock may be undervalued or facing financial challenges.

The PE ratio formula is:

PE Ratio = (Current market price of a share/earnings per share)

Here are the different types of price-to-earnings ratios:

Forward PE ratio

The forward PE ratio is calculated by dividing the current price per stock by the company's estimated future earnings. The ratio is also called the estimated PE ratio.

Trailing PE ratio

The trailing PE ratio is calculated by dividing the current market price per share by the company's past earnings for a specific period. It is the most commonly used ratio by investors. 

Value investing is a method where investors identify undervalued stocks with high growth potential to invest in and hold for a long time. Such investors analyse stocks based on their price-to-earnings ratios to determine their intrinsic value and whether they are undervalued or overvalued. Generally, value investors look for companies with a low PE ratio, as this suggests that they may be undervalued.

Here is the difference between absolute PE ratio and relative PE ratio:

Absolute PE ratio

The absolute PE ratio includes both the forward or trailing PE ratio, where the current share price is divided by either the estimated future earnings or the past earnings.

Relative PE ratio

The Relative PE ratio compares a stock's PE ratio to a benchmark, such as the market or industry average. It helps assess whether a stock is overvalued or undervalued relative to its peers.

A good PE ratio varies and depends on several factors, such as the industry to which the company belongs, the current market condition, and the company’s growth potential. However, investors believe that a PE ratio between 15 and 25 is ideal as it means that the investors are willing to pay 15 to 25 times the company’s EPS. A PE ratio lower than 15 may suggest undervaluation, while a PE ratio higher than 25 may suggest strong future growth.

Although investors widely use the price-to-earnings ratio for stock analysis, they consider its limitations. One major drawback is that the PE ratio does not account for a company's future growth potential and may provide misleading results. Companies may influence the PE ratio through accounting practices, which can mislead investors. Furthermore, the PE ratio varies significantly across industries, making cross-industry comparisons difficult.

The price-to-earnings ratio is a stock market metric that allows investors to determine whether the stock is undervalued or overvalued, and it is ideal for value investors when doing fundamental analysis. Now that you know PE ratio meaning, you can better analyse stocks to ensure you earn profits and reduce the chances of losses.