Definition: The Price-to-Earnings Ratio (PE Ratio) is the quantitative relationship between the stock price and EPS (Earnings Per Share). It offers investors a real-time sense of the value of the organisation.

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What is the Price-to-Earnings Ratio (PE Ratio)?

The PE Ratio (Price-to-Earnings Ratio) is a metric investors consider when analysing the potential of stocks to deliver returns in the future. One can easily assess the relative value of equities of the companies with this parameter. In a situation with a high PE Ratio, investors can consider that the stock will yield more in the coming years.

Price-to-Earnings Ratio (PE Ratio) Formula

P/E Ratio = Last Traded Price of a Stock / Earnings Per Share

One can calculate the PE Ratio by dividing a stock’s LTP (Last Traded Price) by its EPS (Earnings Per Share). After this division, the result is multiplied by 100.

A higher PE Ratio indicates that investors are paying more to buy the company’s stocks. Moreover, the decline in the PE ratio will lower the value of stocks as investors are able to purchase them at cheap prices.

The PE ratio is divided into two parts: forward PE and trailing PE. Investors use the forward PE ratio to predict future earnings, whereas they use the trailing PE ratio to predict past years’ earnings. Depending on their needs and requirements, they can use both. Let’s explore both of them deeply.

Forward Price-to-Earnings Ratio (PE Ratio) Formula

Forward PE Ratio = Last Traded Price of a Stock / Projected Earnings Per Share

Forward PE is commonly used to assess a company’s potential to earn in the coming years. This indicator allows one to compare current earnings with future earnings. To calculate this ratio, consider margins, EPS, profit and loss, and forecast sales. Organisations provide guidance related to their future earnings, making the calculation of the forward PE ratio easier for investors.

Trailing Price-to-Earnings Ratio (PE Ratio) Formula

Trailing PE Ratio = Last Traded Price of a Stock / 1 Year Earning Per Share

Investors can easily calculate the trailing PE ratio as companies declare their financial results every quarter. This provides them with an accurate and objective view of the stock’s performance in the upcoming decades. However, the use of a trailing PE ratio might offer biased analysis as it relies on fixed EPS, but stock prices are dynamic.

Aspects Related to Price-to-Earnings Ratio (PE Ratio)

Most investors in the stock market consider the PE ratio a key indicator of analysis. It reflects how much they are paying for the profit. For example, if a stock is trading at a PE ratio multiple of 10x, then investors are paying $10 for $1 of earnings. Let’s explore some of the key aspects related to the PE ratio.

Investors prioritise the PE ratio to identify stocks with higher growth potential.
In a volatile market, the PE ratio could be one of the most crucial parameters to identify an organisation with high earnings.
Investors can evaluate the overvaluation and undervaluation of shares compared to earnings with the help of the PE ratio.
The high PE ratio shows that the stock is overvalued compared to the company’s earnings per share.
A low PE ratio indicates that stock is undervalued relative to the earnings per share of the organisation.

Note: Calculate and compare the PE ratio with different stocks of identical industries across the country.

A Good Price-to-Earnings Ratio (PE Ratio): What is it?

Similar organisations operating in identical sectors performed differentially in the stock market. And the PE ratio acts as a quick way to value the best among them based on their earnings.

Organisations with higher earnings would have a high PE ratio. So, it is hard to use a specified PE level to analyse the growth potential of all stocks simultaneously. A good PE ratio is when the stock trades near the lower end of the range. Investors consider it the right time to invest in a stock. One should consider the past PEs of the stocks to identify the range.

There is no PE level that investors can consider wholly relying on when investing in stocks. They should use many other indicators like the weighted average cost of capital, relative strengths, average directional index, and discounted cash flow.

Limitations to Price-to-Earnings Ratio (PE Ratio)

As a key metric for technical analysis in the Indian stock market, the PE ratio offers investors knowledgeable insights. However, it also includes several limitations. These are as follows.

Stocks related to different industries trade in their own valuation ranges. So, investors can not compare them with each other to identify the cheaper stock with steady growth potential.
PE ratio can be biased as it can be calculated on the basis of historical performance or expected future performance of the company. And both of them are unreliable.
While calculating the PE ratio, it is not essential to consider the EPS growth rate of the stock. Hence, some investors consider PEG (Price to Earnings to Growth) ratio in their technical analysis.

Absolute Vs Relative Price-to-Earnings Ratio (PE Ratio)

To determine the current and future performance of a company, one can consider two different types of PE ratios: Absolute PE Ratio and Relative PE Ratio. Scroll down to explore more.

1. Absolute Price-to-Earnings Ratio (PE Ratio)) Formula

Absolute PE Ratio = Current Stock Price / Earnings Per Share (EPS)

In this PE ratio, analysts should divide the current stock price by the company’s EPS. This metric is used to determine whether the stock is undervalued or overvalued to the earnings. The higher absolute PE ratio indicates that the company is projected to earn more in the coming years. However, the low absolute PE ratio gives the opposite signal.

2. Relative Price-to-Earnings Ratio (PE Ratio) Formula

Relative PE Ratio = Current PE Ratio / Benchmark PE

In this PE ratio, investors can compare the absolute PE with a benchmark of the past 10 years’ PE ratios. If the relative PE is less than 100, then it is deemed that the current PE ratio is lower than the past PEs. However, if the relative PE is more than 100, then investors consider that the current PE ratio is greater than past ones. Application of relative PE could benefit investors with exemplified stock analysis to generate higher returns.

Let’s Wrap on Price-to-Earnings Ratio (PE Ratio)

Nowadays, investors consider the PE ratio to be an excellent metric for stock analysis. It indicates whether the stock is undervalued or overvalued relative to the company’s earnings. One can compare the PE ratio of two different companies engaged in identical sectors to select the best investment option. Despite being a key technical indicator, it also comes with some limitations. These include inappropriate for future aspects and not comparable in distinguished sectors.

FAQs On Price-to-Earnings Ratio (PE Ratio)

1. What is the Price-to-Earnings Ratio (PE Ratio)?

Ans. The PE ratio is a metric investors use for their technical analysis to identify the potential stocks to buy. It shows the quantitative relationship between the current value of the stock and the earnings per share of the company. You can assess the relative value of the company with the PE ratio.

2. What are the Price-to-Earnings Ratio (PE Ratio)?

Ans. The PE ratio never showcases future earnings growth. It can be calculated based on previous years’ earnings or the company’s guidance related to projected earnings. In addition, we can not compare the PE ratios of stocks operating in different industries. It also avoids many other crucial aspects like cash flow position and debt.

3. What does a negative Price-to-Earnings Ratio (PE Ratio) mean?

Ans. The negative PE ratio of a stock reflects that the organisation is facing challenges like high debt and insufficient cash flow. It purely indicates that the company is booking losses through its operations in the market. Stocks with a negative PE ratio generally come with higher risks and returns, which totally depend on the company’s credibility to sustain and become profitable.

4. How to interpret the Price-to-Earnings Ratio (PE Ratio) of a stock?

Ans. The PE ratio of a company helps investors analyse the relation between the LTP (Last Traded Price) of equity and the earnings per share of the company. The high PE ratio indicates that stock is overpriced as investors are paying more to buy each quantity. At the same time, a low PE ratio indicates that the stock is undervalued.

5. How to calculate the Price-to-Earnings Ratio (PE Ratio)?

Ans. P/E Ratio = Last Traded Price of a Stock / Earnings Per Share. Divide the current value of stock by earnings per share to get the PE ratio of a stock.

Price-to-Earnings Ratio (PE Ratio) | Definition, Formula, & Examples