What is PE ratio and how does it help in analysing companies?

Price-to-earnings (PE) ratio is a valuation metric that shows how investors view an organisation's potential for profit. Shareholders' investment in the company is a reflection of its potential. Therefore, it shows whether a stock is reasonably priced or overpriced relative to others in the same sector. The current price-to-earnings ratio can also be compared to previous ratios to trace a company's development.

The PE ratio is used to value a company. It measures its current share price relative to its per-share earnings. There are two variations in the price-to-earnings ratio: the trailing P/E multiple and the forward P/E multiple.

Most equity valuations use this multiple. Equity multiples are used to determine the rate of return on an investment, either hypothetical or actual. Since this information is readily available, the price-to-earnings ratio is frequently employed in evaluating stock value. This holds valid both for past and future earnings. 

The PE ratio also benefits the discounted cash flow valuation (DCF) method in that it is not as vulnerable to changes in the underlying assumptions. Valuations derived from DCF are highly sensitive to Weighted Average Cost of Capital (WACC) changes and growth rate assumptions. As a result, the price-to-earnings ratio is often employed to evaluate businesses operating in the same market. 

This method of valuing also necessitates less work than others. In contrast, building a standard DCF model can occupy an analyst for up to two weeks. A PE comparison can be created for the same valuation in hours. 

Formula for PE ratio 

Earnings per share (EPS) are compared to the stock price to determine the price-to-earnings (PE) ratio. In other words, it compares the cost of buying a company’s share to its earnings. 

PE ratio = stock price/earnings per share (EPS) 

What does the PE ratio indicate?

A low price-earnings ratio formula indicates a stock is inexpensive, whereas a high ratio indicates an expensive stock. 

Investors' expectations for future earnings growth can also be estimated from the PE ratio formula. The ratio's importance in predicting future growth increases as it rises. 

The price-to-earnings ratio is sometimes known as the earnings multiple or simply "the multiple". Both PE and P/E are acceptable. 

The PE ratio formula measures how much an investor pays for each rupee of annual profit. In this case, a ratio of 10 shows that you are prepared to spend Rs 10 for every Re 1 in income. A 10% "earnings yield" is what you can expect to receive as a result. 

A PE ratio of 10 indicates that you will need to wait 10 years to recoup your investment if earnings remain the same. 

Stocks, markets, and even entire sectors can all be evaluated using the PE ratio. It can also assess the relative strengths of various markets and stock exchanges. 

PE ratio types used for analysis  

Trailing 12-Month (TTM PE

The TTM PE is calculated by dividing the current share price by the average earnings per share (EPS) of the most recent four quarters. Companies regularly report their financial data, including EPS, making it simple to compute TTM PE. 

Forward PE

The forward price-to-earnings ratio is the current share price divided by the four-quarter earnings forecast. Expertise is required to calculate forward PE because of the complexity involved in making accurate predictions of future sales, margins, P&L, and EPS. Earnings projections and PE ratios are calculated by analysts using both inside information and information provided by management. 

Absolute PE

The ratio of TTM PE to forward PE, or the ratio of forward PE to TTM PE, is known as absolute PE. One of PE's drawbacks is that companies in various industries trade at vastly different prices. 

Metal stocks typically have significantly lower PE ratios than fast-moving consumer goods (FMCG) stocks. However, this does not necessarily make metal stocks a better investment. Relative PE gets around this shortcoming of the absolute price-earnings ratio formula. 

Relative PE

In calculating a relative PE, the present absolute PE is compared to a range of historical PEs over a relevant period, such as the last 10 years. When calculating a relative PE, the most common practice is to compare the present PE to the range's upper limit. If a stock's highest PE in the past 10 years was 30, and it's trading at a PE of 27 now, the relative PE would be 0.9. 

What is a good P/E ratio? 

The P/E ratio is a key indicator used to value equities. To what extent does P/E matter, though? The answer to that question is industry- and market-specific. 

In most cases, investors should look for a lower P/E ratio, not a high one. When comparing two stocks, the lower PE ratio means the cheaper stock. That's because a lower P/E ratio suggests that the same amount of money may buy a lower level of earnings. 

Of course, there are always exceptions to every rule. 

A common phenomenon is the high P/E ratios of growth stocks, reflecting that buyers are willing to pay a premium for the expectation of future profits. Furthermore, price to earnings ratio is more prominent in some industries than others. 

To know whether a company's share is overpriced or underpriced, you should look at its PE ratio relative to others in the same industry. You can then determine if the stock is reasonably priced or too high. 

Limitations of PE ratio 

The PE ratio doesn't tell me much about the value of the business. Depending on its expected growth rate, it must be compared to similar investments or a fair value "benchmark." 

PE ratio doesn’t take debt into consideration. Businesses with a lot of debt can have a successful day and then go bankrupt the next. Although the PE ratio of a company may be modest and profit growth seems promising, the future may hold unexpected events. So, it doesn't matter if a company has a low PE or its earnings begin to drop and its debt becomes unserviceable. 

Negative earnings mean no business. This may seem like a no-brainer, but the ratio cannot be determined unless the business has achieved profitability.

This does not, however, mean that the PE ratio is entirely meaningless. The PE, PEG, or EV/EBITDA are not the only ratios that determine a company's value. So, it may seem pointless to dwell on the restrictions imposed by a certain ratio. 

FAQs 

Q. P/E ratio: What is it, and why does it matter? 

The P/E ratio provides valuable information to investors. The P/E ratio reveals the current price at which investors are ready to purchase a stock, with an eye on its expected future profits. A stock with a high P/E ratio may be overvalued since it trades at a high price (or multiple) for its earnings. The price-to-earnings ratio measures how expensive a stock is relative to its profitability.  

Q. How to determine the forward PE ratio? 

The forward price-earnings ratio is determined by dividing the expected earnings in the next few months by the current stock price.  

Q. Can the PE ratio be misleading? 

When the price-to-earnings ratio is high, it could mean that investors are anticipating a rise in profits. For example, the P/E ratio may be deceptive if it is calculated using skewed historical data or forward-looking projections.