What is PE Ratio?
A valuation ratio of a company's current share price compared to its per-share earnings. Also sometimes known as "price multiple" or "earnings multiple."
Theoretically, a stock's P/E tells us how much investors are willing to pay per dollar of earnings. For this reason it's also called the "multiple" of a stock. In other words, a P/E ratio of 20 suggests that investors in the stock are willing to pay Rs. 20 for every Rs. 1 of earnings that the company generates.
Calculated as:
PE Ratio = (Market Value per Share / Earnings per Share (EPS)
Why connect price to earnings?
Any share price is built on expectations of a company's future performance. Some of these expectations will be based on fundamentals - such as the company's recent performance, its new product lines, and the prospects for its sector. The rest will reflect prevailing moods, fashions and sentiment.
By relating share prices to actual profits, the P/E ratio highlights the connection between the price and recent company performance. If prices get higher and profits get higher, the ratio stays the same. The ratio only moves as price and profits become disconnected.
For this reason, when the ratio is higher or lower than normal we know that recent profit levels are no longer the main factor in pricing. This might be because change is investor’s expectation of a much better or worse performance next year - or because of sentiments.
What is PE ratio’s Significance?
Growth of Earnings
Although the EPS figure in the P/E is usually based on earnings from the last four quarters, the P/E is more than a measure of a company's past performance. It also takes into account market expectations for a company's growth. Remember, stock prices reflect what investors think a company will be worth. Future growth is already accounted for in the stock price. As a result, a better way of interpreting the P/E ratio is as a reflection of the market's optimism concerning a company's growth prospects.
If a company has a P/E higher than the market or industry average, this means that the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop.
Cheap or Expensive?
The P/E ratio is a much better indicator of the value of a stock than the market price alone. For example, all things being equal, a $10 stock with a P/E of 75 is much more "expensive" than a $100 stock with a P/E of 20. That being said, there are limits to this form of analysis - you can't just compare the P/Es of two different companies to determine which is a better value.
It's difficult to determine whether a particular P/E is high or low without taking into account two main factors:
- Company growth rates - How fast has the company been growing in the past, and are these rates expected to increase, or at least continue, in the future? Something isn't right if a company has only grown at 5% in the past and still has a stratospheric P/E. If projected growth rates don't justify the P/E, then a stock might be overpriced. In this situation, all you have to do is calculate the P/E using projected EPS
- Industry - It is only useful to compare companies if they are in the same industry. For example, utilities typically have low multiples because they are low growth, stable industries. In contrast, the technology industry is characterized by phenomenal growth rates and constant change. Comparing a tech company to a utility is useless. You should only compare high-growth companies to others in the same industry, or to the industry average
Things to remember!!
- The P/E ratio can use estimated earnings to get the forward looking P/E ratio
- Generally a high P/E ratio means that investors are anticipating higher growth in the future
- Companies that are making losses do not have a P/E ratio
- Low or High P/E Ratio could indicate confidence in the management of the company
- The average forward P/E ratio for Indian Market is close to 15 times forward earnings
We will explain concepts of Earning Per Share in the next edition on Mirae Asset Knowledge Academy Tutorials.
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