What is PE ratio?

Updated on: February 16, 2021 ; Investments

Introduction:

When you plan to invest your capital somewhere, especially in stocks, what is the first thing that comes to your mind? Most probably, the price of the stock. That is because you have to pay that price to buy that stock and it is the most popular metric available. This price is influenced by the market forces depending on the supply and demand of the stock.

But how will you know if the stock is fairly priced or not? To know that, you will have to find out the value of the asset (stock). Now, value and price are two very different concepts. Please read here to understand the fundamental difference between the two.

There are many ways to compute the value of any asset or stock. None of them are complete in themselves, so I suggest you try multiple methods for evaluating a stock before investing in it. Knowing the right value of the stock is important to understand if the price quoted is high, low, or at par.

This is where the PE ratio can be helpful. It is a simple and easy to understand metric, that can help check if an asset is attractively priced or not. This article aims to explain the PE ratio in simple terms.

Definition of PE ratio:

PE ratio stands for Price-to-Earnings ratio. It is also known as Price multiple or Earnings multiple. If this sounds a little confusing, don’t’ worry, I will explain the PE ratio in detail.

PE ratio combines the price and the earnings (profits) of a stock into a single metric. The market forces, sentiments, competition, business outlook, and several other factors determine the price of a stock. On the other hand, the actual performance of an underlying business of a company determines the earnings. Earnings are actual numbers and they can’t change. Whereas prices can change based on any factor that governs people’s expectation from that stock.

You divide the stock price by earnings per share (EPS) to get the PE ratio:

This is the price the market is asking for every rupee earned by the stock.

For example, HDFC bank is trading at a share price of 1,443.65/- rupees. It has earnings per share of 55.70/- rupees. So, the PE ratio is = 1443.65 / 55.70 = 25.93

What this implies is that, if you were to buy HDFC bank shares at the current price, then you would be paying 25.93/- rupees for each rupee earned by HDFC bank in the last 12 months.

Types of PE ratios:

There are two main types of PE ratios. One is the most common one – the trailing PE, and the other one is the forward PE.

• Trailing PE: It considers the total earnings per share(EPS) over the past 12 months. This is the most popular PE metric. It is more objective as it doesn’t depend on any analyst’s estimates. It is completely based on the actual profits of the business. But, it has one limitation. As it is a backward-looking metric, it does not say anything about the future. You as an investor should be making your best judgment in deciding what direction the future PE ratio would take from here.
• Forward PE: Now, in this case, the earnings considered are from the future estimated earnings, while considering the current share price. It provides an insight into the earnings of the future, based on analysts’ estimates. But the downside is that these numbers are largely dependant on the intuition, quality of analysis, and opinion of the analyst. Moreover, forward PE will vary from analyst to analyst.

Utility:

Now, coming to the core of this article. What is the utility of the PE ratio or how useful is it to an investor?

PE ratio is undoubtedly a very powerful and useful tool for an investor. It provides a better picture of the share valuation than just the price of the share. Please note, that there is no one magic metric that can tell you the complete story of stock, or any financial asset. Even if someone tells you that there exists one, please don’t believe them. So, even if PE is a very useful metric, never rely on PE alone to evaluate a stock.

As explained earlier, it provides a very simple way to combine the business earnings with the price of a share. It reveals a lot about how the market perceives a stock in terms of valuation and future growth.

One way of evaluating whether the PE ratio for a stock is high or low is by comparing it with the PE ratios of its peers. You can also compare it with the industry PE ratio which is a combined PE of all the stocks in that industry.

PE ratio can be used to get a sense of the valuation of the overall broader market. You can look at the PE ratios of market indices to gauge how the market is being valued compared to its historical values and other markets.

It is a good idea to look at the historical trends of PE ratios, whether you are evaluating a stock, an industry, or broader markets.

It is a very important metric for any investor and should be used in addition to other key metrics while analyzing a stock.

Also, be careful while evaluating the PE ratio for a company. A low PE ratio means that the stock is available at a cheaper price. That doesn’t mean that it is necessarily a good buying opportunity. Do your research to figure out why is the market pricing the stock so low. Is there any fundamental flaw with the company, or has the market overlooked it, and you have found a hidden gem?

Similarly, a high PE ratio doesn’t always mean that you should avoid buying it or sell it. Some companies have a very solid track record and have promising future growth potential. Market prices such companies in anticipation of the realization of these future growths. Such companies that consistently deliver on these expectations, usually trade at higher PE ratios most of the time.

So as an investor you need to look at other factors in addition to PE ratio.

Reliability and Limitations:

We have explained the PE ratio and its usefulness for an investor. But there are a few points that you, as an investor should be mindful of.

• PE mostly refers to past performance. It can give a good sense of what might be in store for the future but don’t take it as a given.
• Forward PE is as reliable as the ability of the analyst to predict the earnings of the company and sentiments of the market in the future.
• PE ratio takes into consideration the future performance of the company while pricing the stock. This is prone to change with altering market conditions and sentiments.
• PE ratio doesn’t say anything about other fundamental factors like cash flow, balance sheet, management quality, competitor’s landscape, etc. It is not a holistic metric.

So, you need to use PE ratio very intelligently before making any financial decision.

Keep investing!!!