Investment word of the day: Price-to-earnings ratio – How do you calculate P/E ratio and why is it important?

Investment Word of the Day: One of the most important questions for an investor is whether to invest in a stock. To determine this, it is essential to know whether a stock is overvalued or undervalued. One of the simplest and most commonly used measures to assess a stock's value is the price-to-earnings (P/E) ratio.

What is P/E ratio?

The P/E Ratio, or price-to-earnings ratio, determines the current price of a company’s share in relation to its earnings per share (EPS). This ratio can be analysed for different periods; however, in most cases, a time period of 12 months is considered.

How P/E ratio is calculated?

The P/E ratio can be determined by dividing the current market price of a share by earnings per share.

Types of P/E ratios

There are two types of P/E ratios based on the earnings.

• Forward P/E ratio: Also known as the estimated P/E ratio, it is calculated by dividing the prices of a single stock and the estimated future earnings of a company. This ratio is mainly used to assess the future performance of the company.
• Trailing P/E ratio: This type of P/E ratio considers past earnings of the company over a period of time. It is commonly used by investors to provide an accurate estimate of a company’s performance.

There are two types of P/E ratios that determine the performance of the company.

• Absolute P/E ratio: It is a straightforward way of calculating the P/E ratio, where the current stock price of a company is divided by either past earnings or future earnings.
• Relative P/E ratio: To compute the relative P/E ratio, the absolute P/E ratio is compared to a benchmark P/E ratio or previous price-to-earnings ratios.

What is a good P/E ratio?

“A high ratio is likely to suggest that investors expect growth to be higher in the future, while a low ratio may indicate an undervaluation or lack of reasonable growth expectations. This metric is essential for making decisions regarding stocks and for investors to undertake an informed selection,” according to Bharat Mundada, Director, Mundada Finserve Pvt Ltd.

“The P/E ratio offers an advantage in that it gives a glimpse into whether a stock is overvalued or undervalued compared to its industry competitors or in terms of historical performance. For instance, a company that possesses a ratio whose value exceeds the sector average may be considered expensive and may lead to a market correction. On the other hand, a stock with a ratio lower than one might create an opportunity to purchase, provided that the fundamentals do not change,” he added.

Why P/E ratio is important?

The P/E ratio essentially tells whether the stock is overpriced or underpriced, helping investors decide whether to invest.

“It is useful especially in the cross-comparison of stocks of the same sector because there are different P/E standards for different industries. For instance, technology-oriented sectors are generally expected to have higher P/E than their peer sectors,” according to Siddharth Maurya, Founder & Managing Director of Vibhavangal Anukulakara Private Limited.

“By leveraging the P/E ratio, Indian investors can take calculated decisions about their portfolios with respect to risk and expectation returns going by the current and expected performance of the firm,” he added.

However, when making decisions, investors must consider other factors besides the P/E ratio, such as earnings growth, industry performance, and prevailing market conditions.