Before investing in an asset class, the investor should make all due diligence to ensure that the particular asset class has a potential to give high returns in future. Equity is also an asset class which is very popular among investors. There are many advantages of investing in equity but proper research and analysis is crucial for making good returns in this asset class. There are many parameters which are helpful in analysis the stocks and ‘Price earnings Ratio, (P/E) ratio’ is one of them. We will learn more about ‘Price- earnings Ratio’ in this post.
What is Price-Earning (P/E) Ratio?
The Price Earnings Ratio (P/E Ratio) is a parameter which is obtained by dividing the market price of the stock by the earnings per share. In other words, price earnings ratio is a parameter that compares the current market price of a stock to its earnings per share (EPS).
P/E= Market Price of Stock/ Earnings Per Share (EPS)
or
P/E= Market Capitalization of Company/ Total Net Earnings of Company
The investors use this parameter for the following analysis:
- Compare the stocks of other companies within the same industry to find the outliners
- To determine whether a particular stock is overvalued, appropriately priced or undervalued
- Make buying, selling or holding decisions based on the value of a particular stock
P/E ratio tells us how the public feels about a particular stock (w.r.t. price) and how well the company is actually earning (EPS).
The P/E ratio can also be understood in another way that it’s a measure of how much investors are paying for every $1 of the earnings of company.
You can understand this by the following example:
Suppose two companies A and B are from the same industry. Company A has a share price of $115 and P/E ratio of 23. Company B has share price of $65 and the P/E ratio is 45. It means that although the share price of company A is more but the investors are willing to pay less price ($23) for every $1 earning of the company as compared to the company B for which the investors are willing to pay $45 for every $1 earning of this company.
How to Calculate P/E Ratio?
To determine the P/E Ratio of a company, you first need to know its Earnings per Share (EPS), which can be calculated by dividing the company’s net profit by number of outstanding common shares. Once you know the EPS, you can calculate P/E ratio by dividing the company’s current share price (market price of share) by its EPS.
Example
A company has earnings of $12 billion and outstanding shares of the company are 3 billion. If the current market price of its stock is $80, then calculate P/E ratio of the company.
Earnings per share (EPS) of the company= $12 billion/ 3 billion= $ 4
P/E ratio= $80/$4 = 20
One can interpret this in a way that the stock of the company is trading 20 times higher than its earnings.
Significance of P/E Ratio
P/E ratio can tell you many things about a company. By comparing the P/E ratio of the shares of the companies in similar industry, you can have an idea about how the public feels about a company and how much the investors are willing to pay for $1 earnings of the company. You can also determine by comparing the P/E ratio, whether a particular stock is undervalued, overvalued or at par.
High P/E Ratio
The stock may be overvalued
If the P/E ratio of a company is significantly higher than those of other companies in the similar industry, the stock of that company may be overvalued. If earnings of a company fall but the price of the stock remains the same, the P/E ratio will increase. It means that the stock is highly priced. It suggests that the stock is not as valuable as reflected by the price.
Investors may be expecting future growth
One of the reason of rise in P/E ratio is the positive sentiment of investors about the company. If the investors believe that the future prospects are good for a particular company, the price of a stock may increase even if the earnings of the company are stable. This will cause increase in the P/E ratio. If this is the case, then the stock is called the ‘growth stock’. It simply means that the investors are willing to pay higher prices for the stock at the current earnings of the company because they expect future earnings to grow substantially.
Low P/E Ratio
The stock may be undervalued
A low P/E may indicate that the stock is not valued according to its earnings. In such a case the stock’s price may remain unchanged while the earnings of the company may increase resulting in low P/E ratio. Investors may take this opportunity to buy more stocks of that particular company with the expectation that the price of the stocks of that company will rise in future to match the earnings of the company. This strategy is called ‘value investing’.
The earnings of the company may have decreased
Another reason for low P/E ratio may be that the earnings of the company may have decreased and the price has also fallen accordingly. This means that the investors are skeptical about the future performance of the company.
How P/E Ratio can be Used to Analyze the Entire Market?
Like the individual companies, P/E ratio for entire stock indexes may be determined. To calculate the P/E ratio of a particular index, the price of every stock in the index is added and then divided by the sum of EPS of all companies included in the index. This P/E ratio is compared with the long term average P/E ratio of the index. A higher current P/E ratio means the stock index is overvalued and a lower current P/E ratio indicates that the particular index is undervalued.
Conclusion
P/E ratio is an excellent technique to determine whether the particular stock is undervalued or overvalued but it should not be the sole criteria to make buying or selling decision for a stock. This technique should be used with other research parameters like market growth potential, industry growth potential, competitive advantage, earnings growth prospects, management team, debt to equity ratio, etc., to take an investment decision.
Also read: What is Book Value Per Share and why is it Important for Investors
