Know more about price-earnings ratio

What is price-earnings multiple?  

The price-earnings ratio or the PE multiple is a valuation measure that indicates how much the market values per rupee of the company's earnings.   

It is computed as - market price per share/earnings per share (EPS). 

PE is represented as a multiple. When one refers to a stock trading at 12x, it means that the stock is trading at twelve times its earnings. This basically implies that for each rupee of earning, the investor has paid Rs 10. The PE multiple based on historical earnings is of limited value.  

There are two types of multiples – Trailing PE multiple and Forward PE multiple.  

Trailing PE formula (TTM or trailing twelve months) = Price per share/EPS over the previous 12 months.  

Forward PE Formula = Price per share/forecasted EPS over the next 12 months.  

Why PE matters?  

PE ratio is the most commonly used equity multiple. The reason for this is the easy availability of data. One can easily find the historical earnings and market price of the listed stocks.   

This ratio is mainly used to find out the value of the company, whether it is overvalued or undervalued. Investors use the PE ratio to determine a company’s valuation while comparing it with other listed companies from the same industry. The P/E ratio differs across industries.  

A high PE ratio indicates that the company is overvalued or overpriced. Sometimes it also indicates that the investors are expecting high growth rates in the future. It is also considered a growth stock.   

A low PE ratio indicates that the company is undervalued. It is also considered as a value stock and looked upon as the right opportunity to invest in.   

However, any investor should not completely depend on the PE ratio while analysing any company. Some of the factors like balance sheet risk, cash flows, debt structure, and quality of earnings are not considered while calculating the PE ratio. Thus, a low PE stock might not always depict that it's undervalued but may suggest that the company is not performing well or something is wrong with the company.