The PE ratio is the last-traded price of a company’s share over the company’s earnings or profits per share (EPS), indicating the price the market is willing to pay for the company’s profits (or bottomline and hence, its way of working).
The higher the PE ratio, the better regarded the company’s stock is in the market (by investors) but at the same time, it is more expensive to buy.
The PE ratio, then, tells us the multiples of EPS that the shares of the company are trading for.
If the EPS of a company was Rs 4 last year, and its current share price is at Rs 20. The PE ratio tells us investors have paid five times the profits per share to buy the stock.
Cyclical industries, which see an ebb and flow in demand with seasons, display lower PE ratios while other industries like pharma and IT, a higher PE ratio.
We may compare the PE ratio of a company with the average PE ratio of its industry, considering it as the benchmark. If the PE ratio is abnormally low or high as compared to the average PE ratio of the industry, it is considered as a red flag.