- The ratio is used to find out the value of the company, whether it is overvalued or undervalued.
- PE ratio, is the ratio of a company’s price per share to earnings per share.
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 bottom line and hence, its way of working).
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 a rise and fall in demand with seasons, show lower PE ratios while other sectors 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. It is considered as a red flag if the PE ratio is abnormally low or high as compared to the average PE ratio of the industry.
About PE Ratio
Perhaps the most popular financial statistic in the stock market discussion is PE ratio. The ratio is used to find out the value of the company, whether it is overvalued or undervalued. Investors and analysts use the PE ratio to determine a company’s relative amount of shares for the company to company comparison, or it can also be used for the company to track its own growth. The high PE ratio indicates that the company is overvalued, or the investors are expecting high growth rates in the future.
The Price-earnings ratio (or price-earnings multiple as it is generally referred to) is a summary measure that primarily reflects the following factors: growth prospects, risk characteristics, shareholder orientation, corporate image, and degree of liquidity.
How does PE Ratio (Price-to-Earnings Ratio) work?
The company’s earnings are significant to determine the value of a company’s stock because it helps the investor to know whether the company is profitable or not, what will be its value in the future. When the growth or the level of earnings of the company remains constant, then the PE ratio is considered as the duration, which will be taken by the company to pay back the amount at which shares were sold. Analyst or investor considers this ratio before investing in a particular company as it gives lookout of the performance of the company, and helps them analyze at what price they should purchase the stock based on the company’s current earnings. 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.
How to calculate PE Ratio?
Investors would like to know the intrinsic worth of an equity share before investing in any company. Through corporate governance, cash flows, risk, and returns, investors analyze the value of the equity shares. But from these valuation techniques, PE ratio is considered as an essential tool to study the credibility of an equity share.
PE ratio is calculated by dividing the market price per share by the earnings per share.
P/E Ratio formula:-
If the current market price of the stock of Horizon Ltd. is Rs.800 and the company’s earnings per share are Rs.80. Then Price-to-earnings Ratio of Horizon Ltd. will be calculated as follows:
P/E = 800 /80 = 10
From the above calculation, it is estimated that the P/E ratio of the horizon Ltd. is ten times, which means that investors are willing to pay Rs.10 for every rupee of earnings.
What does the PE ratio indicate?
The P/E ratio differs across industries and thus, ought to either be compared with its competitors with similar business activity and size or with its historical P/E to assess whether a stock is undervalued or overvalued. Historically there are specific sectors like diamonds, fertilizers, and so on, that command a coffee P/E ratio. There are specific alternative sectors like FMCG, Pharma, and IT that typically have the next P/E. The analysis of high and low P/E is given as follows:
Companies that have a higher price-earnings ratio are considered as a growth stock. If the company has a higher price-earnings ratio, investors will have higher expectations from a company with a higher earnings growth perspective and will show a willingness to pay more as it shows a positive growth performance. But this attitude put a lot of pressure on companies to perform at the investors’ expectation levels and want to justify their higher valuation. In some cases, it can also be referred to as an overpriced stock.
Companies with a lower price-earnings ratio are considered as a value stock. That means the company’s stock is undervalued. Investors look at these stocks as an opportunity. These stocks tempt investors to invest in stocks before the market corrects their value.