What is P/E Ratio in Share Market?

In the stock market, the Price-to-Earnings ratio is one of the most commonly used metrics by investors to assess the value of a company’s stock price. In an ideal world, its share price should reflect its performance. In the share market, very often, that is not the case. The stock price may not correspond to the company’s sales and profits numbers. The current price of a stock is based on the company’s expected value in the future. This estimated future value differs from person-to-person, brokerage-to-brokerage, and institution-to-institution.  

Other factors like past performance, news and rumors circulating about the company, and price manipulation by operators and institutions can result in the share price becoming overvalued or undervalued. It attracts more investors to follow the trend of buying or selling shares of that company.

PE Ratio

The Price-to-Earnings ratio, also known as the PE ratio or PE multiple, is the relationship between the current market price of the company’s shares and the company’s net earnings or profits. Hence the Price-to-Earnings ratio can help investors evaluate whether the market price of the share corresponds to the company’s financial performance.  It indicates how much money an investor is willing to invest in one share of the company for Rs. 1 of its earnings.  The PE ratio can estimate whether a company’s share price is fairly valued, overvalued, or undervalued. 

Earnings are crucial for determining the value of a business’s stock because investors want to know how lucrative a firm is and will be in the future. Furthermore, assuming the firm does not grow and its present profits remain constant, the P/E ratio may be viewed as the number of years it will take the company to regain the required price.

How Does the Price-to-earnings Ratio in the Stock Market Work?

Now let’s have an in-depth discussion on “What is pe in the share market?” Now let’s discuss how it works. The PE ratio of a company will continue to change over time, with the change in the share price and the change in earnings growth reported by the company. It is because a business’ earnings growth can be exponential. The higher the difference between the current price and the EPS, the higher will be the PE Ratio. And if the PE ratio is high, it simply means that the market is willing to pay a higher premium for its share for Rs. 1 of its earnings. It does not directly indicate that the share price is overvalued or undervalued. 

For instance, if the PE ratio of company A is 12, it means the market is willing to pay Rs. 12 for every Rs. 1 the company generates. Whereas the PE ratio of company B is 50, the market is paying Rs. 50 for every Rs. 1 the company earns. But why are investors willing to pay a higher premium for company B? How can one evaluate the company’s share price valuation using the PE ratio? And lastly, how can one tell if the PE ratio of a company is high or low?

P/E Ratio Formula and Calculation

To calculate the PE ratio of a company, you must divide the current market price at which the company is trading by the EPS or earnings per share. The EPS over 12 months is considered while calculating the PE ratio. The company’s earnings per share are available in the annual reports, quarterly financial statements, and company reports. 

The most commonly used PE ratio is the 12 Month Trailing PE ratio. Here aggregate EPS over the last 12 months is considered for calculating the PE ratio. Using the Price-to-Earnings ratio formula, the PE ratio is 15. 

One can even predict the future PE ratio of the company either by using an estimated future EPS instead of the trailing one. The company provides this estimated future EPS in its annual reports, investor presentations, or conference call with inventors. It is called the Forward Price-to-Earnings ratio. It is used to predict the future performance of the company.  However, this EPS is just a prediction, so the company could fail to meet this estimate or even beat this estimate. 

One can even calculate the PE ratio of an industry or indexes like the Nifty 50, Sensex, and S&P 500. One must first calculate the aggregate current market price of all the stocks that make up the industry or index. Then calculate the aggregate EPS of all the stocks belonging to that industry or index. That aggregate price is then divided by the aggregate EPS. 

Valuation From PE

Now, after having calculated the PE ratios of the two companies, an investor needs to analyze the business of company B further to find out why the market is willing to pay a higher premium for company B. Based on the investor’s understanding of the business, there are two conclusions. The first is that the business has a great potential to grow in the future exponentially, and hence the market is willing to pay a high premium for Rs. 1 it currently earns. Whereas the investor could arrive at the second conclusion is that the share price is overvalued, as one cannot see the company exponentially growing its earnings in the future.

Similarly, in case the A, it could be the case that there may not be tremendous growth in the company’s future earnings, and hence a PE ratio of 12 is justified. Or else, the majority of the market has not discovered the company’s earnings growth potential, and the company is highly undervalued. However, to evaluate the business, one needs to analyze the company thoroughly. They also need to keep in mind that they could be utterly incorrect at gauging its potential growth. What businesses they think are overvalued might show significant earnings growth in the future.

Applying the PE ratio formula and calculating the PE ratio of one company, however, is not going to indicate whether the PE ratio of the company is high or not. To know whether the company is trading at a high PE multiple. Like in the example mentioned above, one can only gauge whether the PE multiple of a company is high or low by comparing it to the PE ratio of another company. The other company whose PE ratio is used as a reference is generally from the same industry.

The PE multiples of companies across different sectors or industries may differ widely—for instance, the average PE multiple of companies belonging to the IT sector may be around 30. At the same time, the average PE multiple of companies belonging to the steel manufacturing industry is 10. This difference exists because the market has different expectations from both these sectors. One could also compare the PE ratio of an individual company to the PE ratio of the industry. It is common even to compare the PE ratios of two different industries.

Why Use the Price Earnings Ratio?

Investors like to invest in financially healthy firms that provide a decent return on investment (ROI). Among the numerous ratios, the P/E is used in the research process for stock selection since it allows us to determine whether we are paying a reasonable price.

Regardless of stock price, similar firms within the same industry are put together for comparison. Furthermore, it is quick and simple to utilize when assessing a firm based on earnings. When we see a high or low P/E ratio, we can instantly determine what sort of stock or firm we are working with.

Issues Involved in Price Earnings Ratio?

The PE ratio of a company by itself is not sufficient to estimate its valuation. In simple terms, a company with a high PE ratio compared to another company or the industry indicates that the market estimates high growth in that company compared to competitors, or the company is overvalued. Only after conducting a thorough further study of the business can one conclude. 

Even then, many investors only choose to look at the PE ratio of the company and, based on the number itself, conclude whether the company’s share price is overvalued or undervalued. Often, investors only consider one possibility while looking at the PE value. For instance, if one finds a company with a PE multiple of 7, they jump to the conclusion that the business is undervalued. The case where the business cannot show any significant growth is ignored. 

The PE ratio of a company is generally compared to the PE ratio of another company belonging to the same industry or the average industry PE ratio. The PE ratio of companies belonging to two different sectors may differ widely. For instance, the PE value of the IT sector company in India is generally around 30. At the same time, the PE of a steel sector company is generally in the single digits.  

Another shortcoming of the Price-to-Earnings ratio formula is that one cannot value a loss-making company using the formula since the company is not making any profits. In this case, the company’s EPS is negative. One could argue that one should not invest in loss-making companies since they are very risky, but the PE ratio does not help analyze the company. 

Conclusion

This article, “What is the price to earnings ratio,” explains that the PE ratio is undoubtedly an important tool that can help estimate a company’s share price valuation. Still, estimating valuation should not be the end-all and be-all metric. Investors should use other tools and metrics and not the PE ratio alone to judge a company’s valuation.   

One should look at the PE multiple of a company and ask why this company demands a higher or lower PE ratio compared to the other companies in the industry? 

Established businesses or industries tend to have lower PE because the market does not expect the company or industry to upscale exponentially. One still needs to analyze whether the business faces a threat from a new disruptive business in the foreseeable future.  

New-age companies or industries have high PE multiples because the market estimates such businesses to upscale tremendously. However, if the latter misuses the latter’s growth potential, the share price can come crashing down. Hence, high stocks trading at high PE multiples are generally considered risky bets with the potential to deliver high rewards. One should analyze their risk appetite before investing in high PE stocks.

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