When you decide to invest in the share markets, there are several choices that you need to make. The most crucial of them is selecting the right stocks for your investment. However, choosing the right stock is not as straightforward as it seems. As an investor, you need to take your decision based on several important factors.
Published on 15 June 2022
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One such factor is the price-to-earnings ratio or the PE ratio of the company. It is one of the widely used tools for conducting stock market analysis and taking investment decisions. Let us explore what is PE in the share market, its different types, and how you can use it to make your investment decisions.
What is the PE Ratio in the Share Market?
The price-to-earnings ratio or PE ratio in the share market is the relation between a company’s current share price and its earnings per share (EPS). It reflects the amount that the investors are willing to pay for the company’s profits. As an investor, you can use the PE ratio of a company to evaluate its potential to grow in the future.
A high PE ratio means that investors are optimistic about the company’s growth in the future and are hence, willing to pay more to buy its shares. However, it also means that the company’s stocks are overvalued.
Similarly, if a company’s PE ratio is low, it means that the investors are not expecting it to grow in the future and are hence, not willing to pay a premium for buying its shares.
How to Calculate the PE ratio of a Company?
The PE ratio of a stock or company can be calculated by simply dividing the current market price of a single stock by the company’s earnings per share. Below is the formula for calculating the PE ratio of a stock:
P/E Ratio = Current market price of the share / Earnings per share
As you can see, the P/E ratio signifies how much the investors are willing to invest in a company’s share against ₹1 of its earnings. So, for instance, if the PE ratio of a company is 10, it simply means that the investors are willing to spend ₹10 on a company’s share against ₹1 of its profits.
Quite understandably, in case a company is not making any profits or facing losses, the PE ratio would be negative.
Types of PE ratio
Now that we have discussed what is PE ratio in the share market, let’s have a look at its types:
Forward PE ratio
The forward PE ratio is calculated by dividing the current market price of a share by the estimated EPS of the company over the next 12 months. Since the forward PE ratio is based on the estimations of the future earnings of a company, it is also called the estimated PE ratio.
You can use the forward PE ratio to assess how a company can perform in the future and what can be its estimated growth rate. Calculating the forward PE ratio requires expert guidance since it involves estimations and forecasts of a company’s EPS.
Trailing PE ratio
The trailing PE ratio is calculated in an opposite way to that of the forward PE ratio. It is done by dividing the current market price of a stock by the EPS of the company over the past 12 months. The trailing PE ratio gives a more accurate view of a company’s performance since it involves past data and not future estimations.
You can use the trailing PE ratio to know how a company has performed in the past year and then decide whether to invest in its shares or not. The calculation of the trailing PE ratio is easier since every listed company declares its financial results every quarter.
How to Use the PE Ratio for Making Investment Decisions?
The PE ratio helps you know the past performance of a company and get an estimation of its future growth. You can make your investment decisions based on your understanding and estimations. Here’s what the PE ratio of a company signifies:
A high PE ratio
Generally, a company with a high PE ratio is a good pick for investment as investors are estimating it to grow in the future. That is why they are willing to pay more for its shares. However, a high PE ratio also indicates that a company’s stocks are overvalued, and hence, their prices may fall in the future.
A low PE ratio
Stocks of companies with a low price-to-earnings ratio are considered undervalued. It can be an indication of weak past performance or future estimations. However, if the fundamentals of a company are strong, you can invest in its shares even if it has a low PE ratio. Know more about Fundament Analysis
To Conclude
The price-to-earnings ratio of any company can help you evaluate its worth and anticipate its future growth. Generally, the stocks of companies with high PE ratios are considered good for investment. However, you should also consider several other factors while taking any investment decision. If the fundamentals of a company are strong, you should invest in its stocks irrespective of its PE ratio.
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There is no concrete answer to this question. The goodness of the PE ratio depends upon several factors, including current market conditions, nature of the industry, industry’s average PE ratio, etc. You should look at the PE ratio of other companies in the same industry to decide whether the PE ratio of a company is good or bad.
Although the PE ratio of a company can help you evaluate its current worth and anticipate its future growth, it should not be the sole parameter behind your investment decision. PE ratio does not consider the EPS growth rate of a company, and also, the EPS figures are released every quarter while stock prices fluctuate every hour.
The absolute PE is calculated by dividing the current market price of a company’s share by its past EPS or estimated future EPS. On the other hand, the relative PE is computed by comparing the absolute PE of a company with a benchmark PE ratio.
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There is no concrete answer to this question. The goodness of the PE ratio depends upon several factors, including current market conditions, nature of the industry, industry’s average PE ratio, etc. You should look at the PE ratio of other companies in the same industry to decide whether the PE ratio of a company is good or bad.
Although the PE ratio of a company can help you evaluate its current worth and anticipate its future growth, it should not be the sole parameter behind your investment decision. PE ratio does not consider the EPS growth rate of a company, and also, the EPS figures are released every quarter while stock prices fluctuate every hour.
The absolute PE is calculated by dividing the current market price of a company’s share by its past EPS or estimated future EPS. On the other hand, the relative PE is computed by comparing the absolute PE of a company with a benchmark PE ratio.
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