WHAT IS THE P/E RATIO ? :- DEFINITION AND FORMULA WITH AN EXAMPLE
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The price-to-earnings ratio compares a company's share price with its earnings per share. Analysts and investors use it to determine the relative value of a company's shares in side-by-side comparisons.
Points to learn :-
The price-to-earnings (P/E) ratio is the proportion of a company's share price to its earnings per share.
Formula :-
P/E RATIO = SHARE PRICE / EARNING PER SHARE (EPS)
Examples of the P/E Ratio
Let's clarify this with an example, looking at SBIN . We can calculate the P/E ratio for SBI as of 1st OCT, 2024, when the company's stock price closed at ₹795.50. The company's earnings per share (EPS) for the trailing 12 months was 76.05₹.
Therefore, SBI's P/E ratio was as follows:
₹795.50/ ₹76.05 = 10.46.
[Note :- PE Ratio Can Be Manipulated By Stock Price manipulation or Earning Manipulation. ]
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NIFTY INDEXES AND THEIR P/E :-
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Companies with low asset and working capital requirements usually have High price to earning Ratio while industries like banking and utilities have low price to earning Ratio.
Companies with no earnings or are losing money don't have a P/E ratio because there's nothing to put in the denominator.
[ Example :- Paytm]
P/E ratios are most valuable when comparing similar companies in the same industry or for a single company over time.
[ Note :- Brand Value And Moat Status Of a Business Can Have an Influence On PE Ratio ].
When comparing the P/E ratios of two companies, consider the following steps:
Identify the Companies: Choose two companies within the same sector for a fair comparison.
Calculate P/E Ratios: Look up the current P/E ratios for both companies, make sure you know whether they are trailing or forward P/Es.
Analyze the Ratios:
Higher P/E: Indicates higher growth expectations or possible overvaluation.
Lower P/E: Suggests undervaluation or potential issues.
Consider sector Context: Compare the P/E ratios to the Sector average. Some Sectors naturally have higher P/E ratios due to growth prospects.
Assess Growth Rates: Look at each company's growth rates. A company with a higher growth rate can justify a higher P/E.
Check Out Other Metrics: Combine the P/E ratio with other financial metrics like PEG ratio, debt levels, and profit margins for a decent analysis.
Example:
Company A: P/E Ratio = 25
Company B: P/E Ratio = 15
Analysis:
Company A has higher growth expectations but may be considered overvalued compared to Company B.
If Company A is in a high-growth tech sector and Company B is in a more stable industry, the higher P/E for Company A could be justified.
Limitations of Price Earnings Ratio
Finding the true value of a stock cannot just be calculated using current year earnings. The value depends on all expected future cash flows and earnings of a company. Price Earnings Ratio is used as a good starting point. It means little just by itself unless we have some understanding of the growth prospects in EPS and risk profile of the company.
An investor must dig deeper into the company’s financial statements and use other valuation and financial analysis methods to get a better picture of a company’s value and performance.
Additionally, the Price Earnings Ratio can produce wonky results. Negative EPS resulting from a loss in earnings will produce a negative P/E. An exceedingly high P/E can be generated by a company with close to zero net income, resulting in a very low EPS in the decimals.
DIFFERENT TYPES OF P/E RATIO:-
Trailing P/E: Determined by using the previous twelve months earnings.
Forward P/E: Predicted on earnings for the following twelve months.
Justified P/E = Dividend Payout Ratio / R – G
where;
R = Required Rate of Return
G = Sustainable Growth Rate
Justified P/E Ratio
The justified P/E ratio above is calculated independently of the standard P/E. In other words, the two ratios should produce two different results. If the P/E is lower than the justified P/E ratio, the company is undervalued, and purchasing the stock will result in profits if the alpha is closed.
Understanding a Good P/E Ratio
A question that riddles investors when using P/E ratio to decide where to invest is what can be considered as a good or safe ratio. However, it is essential to note that the goodness of a ratio varies depending on the current market conditions, the industrial average of P/E ratios, nature of the industry, etc.
Hence, when investors assess different P/E ratios, they should consider how the other companies in the same industry with similar characteristics and in the same growth phase are performing.
For instance, if Company A has a P/E ratio of 40% and Company B with similar characteristics in the same industry demonstrates a ratio of 10% it essentially means that shareholders of company A have to pay Rs. 40 for Re. 1 of their earnings and shareholders of company B have to pay Rs. 10 for Re. 1 of their earnings. Hence, in this instance, investing in Company B might be more profitable.
While high ratios are associated with the risk of value trap investments, lower ratios might indicate the subpar performance of a company owing to internal faults.
Hence, there is no fool proof P/E ratio that investors can rely on when investing in the stock market. In this respect, other technical analysis indicators such as discounted cash flow, the weighted average cost of capital etc. can be used to ascertain the potential profitability of a company.
WHAT IS A LOW OR HIGH PE RATIO?
Answer to this often asked question is that we cannot really generalized a specific number as high or low PE ratio and main reason behind this answer is PE Ratio exclude so many important information about a business's financials.
Fundamental side of investing depends on so many unpredictable and changing part of a business and each business is like a different animal species ...we cannot judge every business the same way... so we as a investor have to be discipline and patience with our investment descision because we only need one oppertunity to make long lasting wealth.
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