What is P/E Ratio? How to Use the P/E Ratio

 There are many things we have to see before buying any stock in the stock market. One of the important points is the P/E Ratio (PE Ratio). When you go to buy an item in the market, you pay the price according to that item. At the same time, you also compare the value of that item with its other alternatives. By which you know whether you are paying more value for that item.


So can we find out in the stock market also whether a stock is cheap or expensive? Somewhere we are not buying any stock at very high price. To find this out, the P/E Ratio is used.

Today we will talk in detail about P/E Ratio in this article of how to choose a good stock. In this article, you will get the answer of all the questions related to PE Ratio. Also, you will be able to use the PE ratio properly. It will include What is PE Ratio, PE Ratio Calculation and How to Use PE Ratio?

What is PE Ratio?

The P/E ratio is the most popular financial ratio. P/E Ratio means Price to Earning Ratio. PE Ratio tells us how many times a company's shares are trading in the stock market in comparison to its EPS.

Thus, the price-to-earnings ratio shows the relationship between the company's stock price and EPS. Let us understand the meaning of P/E ratio with this simple example –

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Suppose there is a company which earns ₹ 100 in a year. Let's assume that there is only one share of it in the market which you have bought. Its current market price is ₹1,000 and the P/E ratio is 10. It means you have given ₹1,000 to earn ₹100 for a year. Here you have to pay 10 times the P/E ratio. In other words you are giving 10 rupees to earn one rupee.

PE Ratio Formula and Calculations

The PE ratio is calculated by taking the share of EPS in the share price of the company.

P/E Ratio = Current Share Price EPS

Suppose the current share price of a company is ₹ 90 and EPS ₹ 10. Now what will be the PE ratio –

PE Ratio = ₹90 ₹10 = 9

This means that you have to pay ₹ 9 to earn one rupee of the company as profit.

What is EPS – EPS means Earning per share. It is calculated by dividing the total outstanding shares in the net income of the company. In this way, EPS tells the earning of a share.

EPS tells us how much profit a company is making on a single share. The higher the EPS, the better it is considered.

Let us understand the PE ratio along with the calculation of EPS –

Suppose there is a company which has 1000 shares and the company earns Rs 2 lakh in a year. In this case the EPS (Earning per Share) of this company will be – 2 lakh 1000 shares = ₹ 200 per share.

If the current market price of the company is running at ₹2,000, here the PE ratio would be – 10 (₹2,000 200)

Here a share earns ₹ 200 in a year and to earn this ₹ 200 you have to pay 10 times the price.

Types of Price to Earning Ratio

There are mainly two types of PE ratio. Both of these depend on the nature of income of the company.

(i) Forward P/E Ratio – As the name of this ratio suggests, this PE ratio is calculated based on the estimate of future earning of the company. This PE is calculated by dividing the company's estimated future earnings in the company's share price.

This PE ratio is not so reliable because of the company's estimated growth and projected earnings being used.

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(ii) Trailing P/E Ratio – This PE ratio is calculated on the basis of Past Earnings of a company. These PE ratios are more accurate which gives the real position of the company. The current market price of this company is calculated by taking the share of past earnings.

P/E Ratio and Value Investing

You must have heard that stocks with high PE ratio are expensive while stocks with low PE ratio are cheap. If this is indeed the case then all the people who invest in the stock market today would have been rich by investing in stocks with low PE ratios.

It is true that higher the price-to-earnings ratio, the more expensive the stock will be, but it does not stand up to value investing. There are many other parameters on which you have to test the company.

If the PE ratio of a stock is very high, it indicates that the current market price of the stock is higher than the EPS of the company. Value investors avoid buying this type of stock which is also fair to some extent.

On the other hand, a company whose PE ratio is very low indicates that the company is trading at a lower market price than its EPS. Stocks with low PE ratio have room for growth, hence value investors prefer to buy this type of stock.

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But in reality, value investing is considered when you hold good stocks for a long time. Even if you have bought a stock today at a high PE ratio, if that company is able to increase its earnings in the future, then you can also buy the stock at a high P / E Ratio.

How to use P/E Ratio?

You have understood the meaning of PE ratio but now the next question comes how to use P/E ratio. The P/E ratio is a very important financial ratio that you must use while choosing a stock.

With the help of the following points, you can make the best use of the P/E ratio –

(i) Let's say SBI bank whose present P/E ratio is 50 and HUL whose P/E ratio is 100. Now you will find SBI Bank shares cheaper than HUL according to PE ratio here. But is it really so? SBI which is a banking sector company and HUL which is an FMCG company. How can these two different sector companies be compared?

After all, how to use the PE ratio?

The PE ratio can never be used to compare companies from different sectors. If you want to do the valuation of SBI Bank, then you have to compare it with any company in the banking sector or with the entire banking sector. Just as a single company has a PE ratio, the entire industry also has a PE ratio.

The PE ratio of the banking sector is made up of the average of the PE ratio of all the banks. Let us assume that at present the PE Ratio of the banking sector is 65. This means that SBI Bank whose PE ratio is 50 is trading at less than the PE ratio of its sector. Thus SBI is getting you cheaper than the sector average PE ratio.


On the other hand if FMCG sector whose PE ratio is 80. The same HUL's PE ratio is 100, which means that HUL is operating at a higher price than the average PE ratio of its sector. This company can be termed as overvalued as it trades higher than the industry PE ratio.

(ii) It is not that if a stock is costlier than the PE of its industry, then it will be correct. If that stock has good earning potential, then investors will be ready to buy it at a higher price. Due to which its price to earning ratio will continue to increase.

(iii) The average method is another way of using the PE ratio. Check the average PE ratio of about 5 years of each stock you want to analyze. If the average PE ratio of that stock is higher than the current PE ratio, then that stock is trading at a price lower than its average PE. These are signals for you to buy that stock. As the 5 year PE Ratio of ICICI Bank is 50 and it is currently trading at the PE Ratio of 40, then it will be said to be cheaper than its Historical PE Ratio.

Shouldn't one buy stocks with high PE ratio?

It is true that the higher the PE ratio of a stock, the more expensive it will be. But it is not right to buy a stock only on the basis of its PE. Let us see some examples for this –


ABC कंपनीYear – 1 Year – 2 Year – 3 
EPS101112
Market Price per Share100110120
P/E Ratio101010
XYZ कंपनी
EPS102040
Market Price per Share1505001600
P/E Ratio152540
Which company would you prefer to choose from the above two companies? Company ABC which is increasing its earnings by 10% every year and its P/E is also maintained at 10. Or Company XYZ which is doubling its earnings every year, due to which its PE has increased from 15 to 40.

Even though the P/E ratio is higher than that of the other company, it has also shown very good growth which justifies its high PE.

In conclusion, an increase in the P/E ratio is considered a good sign due to the increase in earnings.

Let us see this with another example –

ABC कंपनीYear – 1 Year – 2 Year – 3 
EPS1008050
Market Price per Share20001200500
P/E Ratio201510
XYZ कंपनी
EPS103070
Market Price per Share1004501400
P/E Ratio101520
In this the PE of company ABC has come down from 20 to 10. The main reason for the decrease in PE is the fall in the income of the company. Therefore, despite the low PE Ratio, this company is neither attractive nor undervalued at all.
On the other hand Company XYZ whose earnings are increasing very much but its share price is not increasing in comparison to that. In this, the EPS has reached 7 times but the P / E Ratio has increased only 2 times. There can be many reasons for a low P/E ratio. These companies can be a good company to invest in provided they meet other parameters. XYZ Company is a company with high growth and moderate PE.

Due to low P/E ratio

  • Stocks can be undervalued.
  • Low growth and low profit of the company.
  • Not likely to do well in future.
  • The reason for the low PE ratio may be one or all of the above reasons together.

Due to High P/E Ratio

  • Stocks may be overvalued.
  • High growth of the company.
  • Huge growth potential in future.

Limitations of P/E Ratio

Although the PE ratio is a very good way to judge a company, one can never buy shares by looking at the PE alone. There are some limitations of the P/E ratio that you need to keep in mind.

(1) Price to Earnings Ratio is arrived at on the basis of earnings only. In this the debt of the company is ignored. You can find a company with a good P/E ratio. But that company can have a lot of debt which is not good for any company at all.

(2) The P/E ratio assumes that the earnings of the company will remain constant but it does not. The earnings of the company also depend on many other factors.

(3) Generally a company whose P/E ratio is 15 and a company whose P/E ratio is 10. In this, a company with 10 PE will be considered cheap. But PE ratio will not tell you which company is making quality earnings.

(4) The P/E ratio is worked out on the basis of the current market price of the stock which varies daily on the trading day. Because of this PE can give you the wrong picture.

What is a good P/E Ratio

There is no set standard for the P/E ratio. You can compare a company's PE with its sector PE. Also you can compare the PE of the company with the PE of its rival company. This will give you an idea whether the PE you are getting is less or more.

How to see the PE Ratio of the company?

You can check the PE Ratio of any company through Moneycontrol's website or mobile app. Here you get the information of the company's PE, Consolidated PE and Sector PE together.

Apart from this, you can also use websites like Tickertape, Morning Star, Value Research etc.

Conclusion

There are many parameters to measure any good stock. One of the parameters is the P/E ratio. It is not that you can choose the best stock on the basis of P/E ratio alone. Yes, PE ratio helps you a lot to filter out the bad stocks.

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