P/E ratio formula
= Market price per share ÷ Earnings per share
= Rs. 100 ÷ Rs. 5
= 20
This means that shareholders are willing to pay 20 times the earnings for each share of the company. A high P/E ratio indicates that the share price is high compared to the company’s earnings, hinting at a possible overvaluation. Conversely, a low P/E ratio can mean the company’s shares are undervalued.
Types of price to earnings (PE) ratio
Two types of P/E ratios are outlined below based on the data used to compare the share price and its earnings.
1. Trailing P/E ratio
The trailing P/E ratio uses historical data and relies on the company’s past performance to determine its valuation. Here, the current market price of the company’s shares is divided by its total EPS over the past 12 months.
On the upside, this type of P/E ratio uses accurate or already available data. But on the flip side, the prices may be outdated since past performance does not guarantee results in the future.
2. Forward P/E Ratio
As the name indicates, the forward P/E ratio relies on projected or estimated earnings. It compares the current market price of a company’s shares with its estimated earnings for the next 12 months.
The main limitation of the forward P/E ratio is that the projections may be inaccurate. If a company underestimates its future earnings, it may lead to a higher P/E ratio. And if the future earnings are overestimated, the P/E ratio may be lower, making the shares seem undervalued.
Absolute P/E ratio and Relative P/E ratio
The P/E ratio can be categorised into two types: Absolute P/E ratio and Relative P/E ratio. Here’s an explanation of both:
1. Absolute P/E ratio
The Absolute P/E ratio, often referred to simply as the P/E ratio, is the straightforward calculation of a company’s current stock price divided by its earnings per share. This ratio gives investors a snapshot of how much they are paying for each rupee of the company's earnings.
Formula:
Absolute P/E ratio = Current stock price/Earnings per Share (EPS)
Uses and interpretation:
- Valuation benchmark: It is used as a benchmark to determine whether a stock is overvalued, undervalued, or fairly valued compared to its earnings.
- Comparative measure: Investors often compare a company’s absolute P/E ratio with the industry average, market average, or historical P/E ratios of the same company.
- Growth and expectations: A higher P/E ratio may indicate that investors expect higher earnings growth in the future, while a lower P/E might suggest the opposite or signal that the stock is undervalued.
2. Relative P/E ratio
The Relative P/E ratio compares the current P/E ratio of a company to a benchmark P/E ratio, which could be the historical average P/E ratio of the same company, the average P/E ratio of the industry, or the overall market P/E ratio. This ratio provides context to the current P/E ratio by showing how it stands relative to these benchmarks.
Formula:
Relative P/E Ratio = (Current P/E Ratio)/(Benchmark P/E)
Uses and interpretation:
- Historical comparison: By comparing the current P/E ratio with historical averages, investors can assess whether the stock is trading at a higher or lower valuation than usual.
- Industry and market comparison: Comparing the P/E ratio to industry or market averages helps investors understand how the company is valued relative to its peers or the overall market.
- Contextual valuation: The relative P/E ratio provides a more nuanced view of valuation, accounting for broader market conditions and industry trends.
Example: If a company has a current P/E ratio of 20, the historical average P/E ratio is 15, the industry average is 18, and the overall market average is 25:
- Relative to historical average: 2015=1.331520=1.33 (The current P/E is 33% higher than its historical average)
- Relative to industry average: 2018=1.111820=1.11 (The current P/E is 11% higher than the industry average)
- Relative to market average: 2025=0.802520=0.80 (The current P/E is 20% lower than the market average)
Understanding both Absolute and Relative P/E ratios allows investors to make more informed decisions by not only assessing the intrinsic value of a stock but also placing that valuation in the broader context of historical performance, industry standards, and overall market conditions.
Understanding a good P/E ratio?
When evaluating investment opportunities using the Price-to-Earnings (P/E) ratio, investors often grapple with determining a suitable benchmark. It's important to recognise that the "goodness" of a P/E ratio is contingent upon various factors, including prevailing market conditions, industry averages, and the specific nature of the business.
To make informed comparisons, investors should assess how a company's P/E ratio stacks up against peers within the same industry, with similar characteristics and growth trajectories. For example, a company with a P/E ratio of 40 is trading at a significantly higher premium compared to a peer with a ratio of 10. This suggests that investors are willing to pay more for each rupee of earnings in the former company.
While high P/E ratios may signal potential overvaluation, low ratios could indicate suboptimal performance or underlying issues. Therefore, relying solely on the P/E ratio for investment decisions can be risky. To gain a more comprehensive understanding, investors should consider additional financial metrics such as discounted cash flow and weighted average cost of capital.
Relationship between forward and trailing P/E ratios
The trailing and forward P/E ratios can be used in conjunction with one another to get a more comprehensive picture of a company’s valuation. If you’ve been tracking the company’s forward P/E ratio for the past year, you can compare the projected ratio with its actual trailing P/E ratio. This will help you estimate how accurate the company’s future projections are.
Using P/E ratios to determine investment strategies
The P/E ratio can be instrumental in formulating long-term investment strategies. If the P/E ratio is high, it typically indicates that investors are currently paying a premium for the company's shares, even though its earnings are low. Over the long term, price corrections may occur, bringing the company’s share price lower and closer to its intrinsic value.
On the other hand, if the P/E ratio of a company is currently on the lower end, it means that the market may be undervaluing the company — even though its earnings are high. Over time, when investors realise the company's true worth, they may drive the price up, leading to long-term capital appreciation.
Sector-wise PE ratios: Comparing Companies Using the P/E Ratio
There is no absolute cut-off for determining a good P/E ratio from a bad one. Instead, a more effective strategy is to compare the price-to-earnings ratios of two different companies within the same industry or sector to get more clarity about their valuation. If the price-to-earnings ratio for a company is higher than the sectoral average, it may be indicative of overvaluation (and vice versa).
Relationship between P/E ratio and value investing
Value investors prioritize the intrinsic value of a company's underlying assets over its current market price. The Price-to-Earnings (P/E) ratio is a crucial tool in this approach, helping to identify potential mispricings.
A high P/E ratio suggests that a company's share price is significantly higher relative to its earnings, potentially indicating an overvalued stock. Value investors generally avoid such stocks, as they may be subject to speculative bubbles and prone to significant price corrections.
Conversely, a lower-than-average P/E ratio may suggest that the stock is undervalued, offering a potential buying opportunity. However, it is crucial to consider the industry average P/E ratio, as valuations can vary significantly across sectors.
Value investing typically requires a long-term investment horizon to fully realise its potential returns.
Limitations of the P/E ratio
Despite the many insights you can get with the P/E ratio in the share market, this metric has its limitations. They include the following:
- The ratio does not factor in a company’s debts.
- It does not give you insights about the company’s cash flow.
- You do not learn any material information about the quality of the company’s earnings.
- It is not very effective for comparing companies in different sectors or industries.
Conclusion
The bottom line is that a company’s P/E ratio is not a foolproof indicator of its valuation. It is best to combine the P/E ratio in the share market with other indicators and ratios like the price-to-sales ratio, price-to-book ratio, debt-to-equity ratio, and dividend yield. This will give you a comprehensive overview of the company’s future prospects.
Additional topics you may want to read about
Is negative PE ratio good?
A negative P/E ratio indicates that a company is currently experiencing a net loss. While this may signal risk, it can be acceptable in high-growth sectors where profitability may take time to materialize.
What if PE ratio is less than 1?
A low P/E ratio can indicate that a stock is undervalued and may have the potential for future price appreciation.
What is the PE ratio in the share market?
The Price-to-Earnings (P/E) ratio is a key valuation metric that reflects the market's perception of a company's future earnings potential. It represents the amount investors are willing to pay for each rupee of earnings generated by the company.
