You must have heard the term P/E ratio a lot of times, but do you know what it really means and what do PE ratio figures imply? Well in this article, we are going to talk about the same.
What is PE Ratio?
The P/E ratio, or price to earnings ratio, is the relationship between the current share price of a company and its earnings per share (EPS). For the calculation of this ratio, analysts and investors can use earnings from different time periods; however, earnings from the last 12 months or a full year are most commonly considered.
How Do You Calculate P/E Ratio?
Here’s the PE ratio formula you can be used for calculation:
EPS (earnings per share) is simply determined by dividing the current stock price by the P/E value. For example, if the current price of a stock is Rs. 100 and it has earned Rs. 5 per share (EPS) for its shareholders in the past 12 months. The P/E ratio works out to be 100/5=20.
Types of Price to Earnings Ratio
There are two main types of P/E Ratio which financial analysts take into consideration – forward P/E ratio and trailing P/E ratio.
Forward Price-to-Earnings Ratio
The forward P E is calculated using projected earnings rather than trailing figures. Also referred to as “estimated price to earnings,” the forward-looking indicator helps in comparing current earnings to future earnings. It shows what earnings will look like without accounting adjustments.
Trailing Price-to-Earnings Ratio
Contrarily, the trailing P/E is calculated by considering the current share price and total EPS earnings over the last 12 months. Since it assumes the company’s reported earnings
It is more objective than the forward P/E ratio and hence is used more often. However, trailing P/E has some flaws, including the fact that past performance does not always predict future behaviour.
Valuation From P/E
The price-to-earnings ratio, or P/E, is one of the most extensively used stock analysis methods for determining stock value by investors and analysts.
The P/E ratio can illustrate how a stock’s valuation compares to its industry group or a benchmark like the S&P 500 Index
In addition to determining whether it is overvalued or undervalued.
The P/E ratio helps investors in determining a stock’s market value in relation to its earnings.
The P/E ratio indicates how much the market is ready to pay for a stock now based on its previous or projected earnings.
Good PE ratio stocks or high PE ratio means that the price of a stock is higher than its earningsA
nd it may be overvalued. On the other hand, a low P/E might be an indication that the current stock price is low in comparison to earnings.
Limitations of P/E Ratio
P/E ratio analysis can be used to determine whether a company’s shares are overvalued or undervalued, however, it is prone to error.
Additionally, as the P/E ratio does not take into account the EPS growth rate of a company,
Investors use the Price to Earnings to Growth (PEG) ratio to determine which company is the most promising.
It is difficult to make an investment decision solely on the basis of the P/E ratio because earnings are released every quarter
while stock prices fluctuate every day. For this reason, the P/E ratio might not always relate to company performance, allowing investors to make errors.
Therefore, investors should never determine a company’s value solely by looking at its P/E ratio. Several other factors also influence the true value of a stock, which should be considered as well.
For more information about the P/E ratio, or anything related to Finance and investments, check out the InvestYadnya Blog.