What Is P/E Ratio?

The price of an equity share on the stock market shows the current price that market participants are willing to pay to purchase shares of the company. However, the market price of a stock can be influenced by various factors such as market sentiment, economic outlook, current market liquidity, etc. This is where the P/E ratio or price to earnings ratio acts an important metric which tells whether or not the stock price accurately reflects the future earnings potential of the company with respect to its current stock price.

P/E ratio can be thus defined as the amount that market participants are willing to pay for each ₹1 of the earnings per share. If the general sentiment and predictions indicate a rise in future earnings, the market price of shares will increase and vice versa. Now if the stock price rises at a higher rate than the earnings, in that case, the P/E ratio of the stock will be high and it may be considered overvalued. Alternatively, if the market price of the stocks falls at a higher rate than the earnings, then the P/E ratio will be low.

While price to earnings ratio is typically calculated for individual stocks, it is also possible to calculate P/E ratio for stock indices and even for individual stocks held by equity mutual funds. However, due to constant changes in the price of stocks, the P/E ratio of both individual stocks and stock indices keeps on changing. Furthermore, when companies come out with their quarterly reports and earnings, the P/E ratio undergoes significant changes and fluctuations. There are three types of P/E ratios, namely Shriller P/E ratio, Forward Earnings, and TTM Earnings. So let’s see how P/E Ratio is calculated.

There are three ways of calculating the P/E ratios, let’s consider each one of them in detail:

Now that we are through with our discussion on the different ways of calculating the P/E ratio simplify our understanding of how P/E ratio is calculated by using an example. The basic formula to calculate P/E Ratio is this:

P/E Ratio = (Price per Share / Earnings per Share)

Suppose Company ABC is trading at the stock exchanges for ₹250. The annual earnings per share of the company is ₹10. Now using the P/E ratio formula (current stock price/ earnings per share) 250/10 = 25. The Price to Equity ratio comes out to 25. This tells us that if the earnings and stock price of the company remain constant, it would require the company around 25 years to have adequate profits and recover the share price.

Let’s consider a comparative analysis of the P/E ratio of two companies by considering the following information:

One would now think that Company ABC Limited is cheaper because of the lower earnings per share than the company XYZ Limited. However, in a real sense, Company XYZ is cheaper because investors are paying less for every ₹1 of the earnings per year. If we consider the industry average, even in that case, Company XYZ Limited is better priced than other companies in the same industry. This method can be used to evaluate and screen different equity investment options that might be available to you.  

The impact of price to earnings ratio is perhaps best illustrated by index funds that replicate a specific stock index like the Nifty 50 Index or the Nifty 100 Index. The prices of an index fund reflect the overvaluation or undervaluation in the stock markets. Investors can use the P/E Ratio of various indices like Nifty 50, Sensex, Bank Nifty, etc or predict the respective index fund returns. Suppose the P/E ratio of Sensex is falling from its mean value of ₹15 to 14, 12, and 11. However, if there is enough evidence to suggest that the P/E ratio will revert to its mean value, then one can say that it is the best time to invest in an Index Fund that tracks a broad index like the Sensex.

The P/E ratios help in taking important investment decisions. A high P/E ratio of a stock indicates an expensive or potentially overvalued stock and there is a high possibility of a correction or fall in the stock’s price in the future. On the other hand, a low P/E ratio signals an undervalued stock price and indicates possibility of an increase in the share price shortly. While this can help screen potential investments one must take care to factor the price to earnings ratio of a stock versus its peer companies and the industry average before making any type of investment decision. As a result, it is best to seek the help of a financial analyst or investment advisor to stay on the right track.