The price-earnings ratio, often known as the PE ratio, P/E ratio or price to earnings ratio, is a market prospect ratio. It calculates the market value of a stock of a company, as relative to its earnings by comparing the market price per share by the earnings per share (EPS). This ratio shows what the market is willing to pay for a stock based on its current earnings.
PE is a popular ratio that gives investors a better sense of the value of the company. It shows the expectations of the market and is the price you need to pay per unit of current earnings (or future earnings, as the case may be).
We want to know about earnings evaluating a company’s stock because we want to know how profitable a company is and how profitable it will be in the future. This ratio helps us evaluate what a stock’s fair market value should be, by predicting future earnings per share.
Companies with higher future earnings are usually expected to distribute higher dividends. Or more possibilities of increase in stock in the future.
Moreover, if the company doesn’t grow much and the current level of earnings remains constant, the P/E can be understood as the number of years it will take for the company to pay back the amount paid for each share.
PE Ratio Formula
The price-earnings ratio is calculated by dividing the market value price per share by the earnings per share.
This ratio is usually calculated at the end of each quarter when quarterly financial statements are issued. And is calculated at the end of each financial year with the annual statements.
In any case, the fair market value is equal to the trading value of the stock at the end of the current period.
The EPS ratio is also calculated at the end of the period for each share outstanding. A Trailing PE ratio occurs when the EPS is based on the previous period. And Leading PE ratio is the one when the EPS calculation is based on future predicted numbers. A justified PE ratio is measured by using the dividend discount analysis.
- Suppose the current market price of the stock of A Ltd. is Rs. 100 and its EPS is Rs. 10. The Price Earning Ratio of A Ltd. will be calculated as follows:
P/E = 100/10 = 10
The P/E ratio of A Ltd. is ten times, which means that investors are willing to pay Rs.10 for every rupee of earnings.
- B Ltd’s stocks are currently trading at Rs. 50 a share and its EPS for the year is Rs. 5. B Ltd’s P/E ratio would be calculated like this:
- P/E = 50/5 = 10
As you can see, the ratio is 10 times. This means that investors are willing to pay Rs.10 for every Rupee of earnings. In other words, this stock is trading at a multiple of ten.
Because the current EPS was used in this calculation, this ratio would be called a Trailing price-earnings ratio. If a future predicted EPS was used, it would be considered a Leading price-earnings ratio.
Interpreting PE Ratio
1. High P/E Ratio
Companies with high PE ratios are often considered to have growth potential. It means that the market has higher expectations for future earnings growth. And that the investors are willing to pay more for them as it indicates a positive future performance. However, the problem with high P/E is that growth stocks are often unpredictable. It puts a lot of pressure on companies to do more to maintain their higher valuation. Therefore, investing in growth stocks may get to be a risky investment. Also, for some corporates, it can even be interpreted as an overpriced stock.
2. Low P/E Ratio
Companies with low PE ratios are often considered to have underrated stocks. Or that the price of their stock is relatively small. A company with a low PE ratio is usually indicative of a weak current as well as future performance. The lower pricing of stock attracts investors to buy more before the market corrects it. And when it does, investors make a profit because of the stock price increase. However, this could be a poor investment option.
3. Justified P/E Ratio
The Justified P/E ratio is calculated independently of the normal P/E. Unlike the regular P/E ratio, it is not based on the observed price. Instead, inputs such as expected dividend, growth rate, earnings, and cost of equity are used to estimate the P/E. These are based on future cash flows.
Therefore, these two ratios produce two different results.
This is also termed as being “justified” by using the Gordon Growth Model.
If the P/E is lower than the justified P/E ratio, it means the company is undervalued and purchasing that stock will result in profits, if the Alpha Ratio is closed.
Calculating PE Ratio
The basic P/E formula takes the current stock price and EPS to find the P/E. EPS is measured by taking earnings from the last 12 months divided by the weighted average shares outstanding. These earnings can be normalized for unusual or one-off items that impact them unusually.
The justified P/E ratio is used to find the P/E ratio that an investor should be paying for, based on the companies dividend and retention policy, growth rate, and the investor’s required rate of return. Comparing Justified P/E to Basic P/E is a common tool for stock evaluation.
R = Required Rate of Return
G = Sustainable Growth Rate
P/E = Stock Price Per Share/Earnings Per Share
P/E = Market Capitalization/Total Net Earnings
Justified P/E = Dividend Payout Ratio/R – G
Price-Earning Ratio in Stocks
Generally, a high PE ratio indicates that market members are bullish on the stock and expect the company to post higher earnings growth in the future. However, it can also mean that the stock is overpriced, in some cases.
Whereas, a low PE ratio can mean an undervalued stock or market participants are not too bullish on the company’s future earnings growth.
Moreover, the PE ratio varies from industry to industry. So the above may not always be true.
Traditionally, there are some sectors like diamonds, fertilizers or sectors that are very cyclical and command a low PE ratio.
On the other hand, certain sectors like FMCG, Pharma, IT normally have a higher PE. So the PE ratio of a company should either be compared with its peer-group, within the same industry, having a parallel business activity and of similar size or with its historical PE to evaluate whether a stock is underestimated or overestimated.
A high P/E ratio indicates:
- A stock is overvalued and that the investors are expecting a higher growth rate in the future. It may lead to the frenzied buying of stocks. This can bring a sharp increase in the market prices of a stock, and thus multiply the P/E manyfold.
- A high P/E ratio can be justified when the company is expanding. But this may eat up the company’s earnings, thus decreasing the P/E back.
A low P/E ratio indicates:
- The company is currently undervalued or that it is expanding at a very high speed before investors could notice its accelerating growth rate.
- It may also mean that the investors are losing confidence in the potential of the company, thus driving the stock price and P/E downwards.
Price-Earning Ratio in Mutual Funds
While selecting the right stock to invest in, there is much importance of the price-to-earnings (PE) ratio and market capitalization of the stock. When used with other analytical tools, these numbers can help you invest in the right stock at the right time.
But can they also be used for selecting the right mutual funds? You may find it difficult to ascertain The investing style and preferences of the fund manager may not be visible only by looking at the mutual fund portfolio. This is where the fund’s PE ratio and average market capitalization help. They help you make a more informed decision using these ratios.
In mutual funds, the PE of a scheme is arrived at by using a weighted average of all the underlying stocks. It is the average of the PE of all the stocks that the fund’s portfolio contains. Proportionate to their allocation within the portfolio.
A high PE would indicate that the mutual fund investment holds mostly stocks that are quoting a valuation premium. This indicates a preference for growth and growth-oriented businesses. In a growth-based approach, the fund manager does not mind paying a high price for stocks that are displaying good growth in profitability.
On the contrary, a low PE signifies a value-conscious approach. Here, the fund manager is more comfortable investing in stocks that are currently not in demand. Or where the stock price has been beaten down disproportionately to the fundamentals of the company. Growth-oriented funds tend to exhibit strong returns within a short span of time but are quite volatile. Value conscious funds generally earn better results over a longer period of time and come with lesser volatility in returns.
But the PE ratio is not of much use by itself. Experts advise using it along with the average market capitalization to gauge the true investing style of the fund. Both standards should be evaluated.
The valuation metrics in a mutual fund should not be used for timing entry or exit, but for relative comparison.
Caution While Using PE Ratio
Though it is one of the most useful and popular tools for analysts to evaluate the benchmark and give stock advice. Still, you should not rely heavily on PE ratio, as the only criteria, while investing in stocks. You should use it with other valuation tools to arrive at a correct picture. A few more points should be considered before picking the right investment.
Because P/E Ratio suffers from the following problems:
- It is not the only metric that can evaluate your investment decision. Instead, it needs to be used as one of the tools along with financial leverage, expenses, dividend yield, turnover, etc.
- The debt levels can affect a company’s earnings and market price. It means that they can affect the PE ratio as well. Let’s say there are two companies ‘A’ and ‘B’. Now, if company A has more debt than company B, then PE for company A will be lower than the PE of company B.
- This comparison tool should be used only while shortlisting companies operating within the same sector. For example, Telecom and IT companies may exhibit a higher PE as compared to the companies in the manufacturing or textile sector.
- In some industries such as Financial Services, Cement Industry, etc., other valuation approaches are considered more appropriate.
- P/E ratio may not be suitable to value companies in an industry that has high entry barriers.
- The accuracy of the PE ratio depends on the accuracy of its inputs such as EPS and MPS. While the market prices are readily available, the same cannot be said about the earnings which the companies report themselves. Some companies may manipulate the data to skew the price-earnings ratio.
- While calculating the forward-looking P/E ratio, one may use past EPS to determine future performance. If the company has a P/E Ratio of 15 today, it means that the company will continue to provide you Rs 15 on every rupee it earns. However, there is no guarantee that the company will continue to experience the same growth because macro variables, sector-specific trends, change in regulation, etc may change.
- P/E Ratio makes use of only the earnings and market price of an equity share. It doesn’t consider the debt aspect of the company. Some companies are highly-leveraged and can be considered as risky investments. However, the P/E Ratio will not show this aspect.
- The ratio assumes that the earnings will remain constant soon. However, earnings are dependent on a lot of other things and are volatile.
- P/E Ratio doesn’t indicate whether a company’s cash flow is going to increase or decrease in the future. Ideally, an investor wants to invest in a company that keeps generating and increasing cash flows throughout its life.
- PE Ratio doesn’t give you any information about the quality of earnings of the company. If the company which is trading cheap has a poor quality of earnings, then it can’t be ideal, despite being a cheap investment.
Whether the PE ratio is high or low, a lot depends on other factors. Such as the industry, diversification, proportion, market conditions, etc. Many external factors also affect PE Ratio. For example, a merger and acquisition announced by a company will increase the ratio. Therefore, it is vital to analyze the background of the company, consider all other factors too, before one decides to invest.
The company, the management, growth plans, cost of capital, bottom-line and top-line indicators, the strength of balance sheet, etc. must be given due thought, before investing in a stock.
With so many factors to consider for choosing the right mutual fund plan to invest in. Finalizing the right one for your money is an intimidating task.
Therefore, you should take the help of professionals. Therefore, you should let WealthBucket assist you. Let us help you out in short-listing and personalizing your investment.
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