Price Earnings Ratio (P/E Ratio) : What is it and how to use it ?

Price Earnings Ratio (P/E Ratio) : What is it and how to use it?


Introduction 

Price Earnings Ratio is a relative measure used to value a stock. Relative measure makes it comparable to stocks of other companies. Out of many modes of valuation, it is one of the ways for assessing investment viability in stocks. Price Earnings Ratio is relationship between a company's stock price and earnings per share (EPS). Lower the P/E ratio the better deal normally for an investor.

P/E Ratio can be calculated using any of below-stated formulas : 

P/E Ratio = Stock price per share/ Earnings per share

                                    

                                     OR

P/E Ratio = Market Capitalisation/ Total Earnings

Basically, there are two types of P/E Ratio. Trailing and Forward. Trailing is based on previous periods earnings whereas Forward is based on future earnings estimate.

Use of P/E Ratio : 

Looking at the P/E ratio of stock tells you very little about it, if it’s not compared to the company’s historical P/E or the competitor’s P/E from the same industry. It’s not easy to conclude whether a stock with a P/E of 10 times is a bargain, or a P/E of 50 times is expensive without performing any comparisons.The beauty of the P/E ratio is that it standardizes stocks of different prices and earnings levels. In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. 

Companies with a high P/E Ratio are often considered to be growth stocks. Investors have higher expectations for future earnings growth and are willing to pay more for growth stocks. The downside to this is that if the stock is not able to deliver higher growth in future then decline in share price is substantial. For this reason, investing in growth stocks is more likely to be seen as risky investment. Stocks with high P/E ratios are also considered overvalued normally.

Companies with a low P/E Ratio are often considered to be value stocks. It means they are undervalued because their stock price trade lower relative to its fundamentals. This mispricing will be a great bargain and will prompt investors to buy the stock before the market corrects it. Examples of low P/E stocks can normally be found in mature industries. A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends or future expected rate of growth is low.

Normally it is advisable to invest in stocks which have P/E ratio below 20.

P/E ratio can be considered as an important parameter and starting point in stock selection process. However, P/E ratio is not the sole factor to be considered for identifying stock for investment. An investor must dig deeper in the company’s financials and use other valuation and financial analysis methods to get a better picture. 

One can filter for stocks with less than or more than a certain P/E ratio on www.screener.in (The website is free and useful resource for investors.)