The P/E Ratio

Price-Earnings Ratio

What is price-to-earnings (P/E) ratio?

The price-to-earnings ratio is the relationship between the current share price and earnings per share (EPS). It is the ratio between the current share price and EPS. This ratio is also known as price multiple or earnings multiple. Usually, for this, the earnings of a company of the last 12 months or one year are used.

The P/E ratio denotes the amount of money an investor is willing to pay for a single share of a company for Re 1 of its earnings. For instance, if a company has a P/E ratio of 17, it means that the investor is ready to pay Rs 17 for Re 1 of the company’s earnings. It helps us gauge what the market is willing to pay for the company’s earnings.

P/E ratio = current share price/earnings per share (EPS)

This ratio provides an investor with a fair assessment of the value of a firm. Assuming the entity doesn’t grow enormously and furthermore, the current levels of earnings remain more or less the same then, this ratio can also be interpreted as the number of years that will be required for the firm to repay the amount paid for each share.

How is it used?

Merely referring to the P/E of a stock is of a little consequence. The right way to use this ratio is to compare it to the company’s historical P/E, P/E of its peers/competitors, and to the P/E ratio of the industry, as a whole. As such, it is not advisable to use this ratio without due comparison and it is uncertain if a stock with a certain P/E is a bargain or expensive. The P/E ratio is different for different sectors. Certain sectors like fertilizers or cyclical sectors have a low PE ratio. Other sectors like FMCG, Pharma, and IT normally command a higher PE. Hence, the PE ratio of the company should be either compared to its peers having similar business activity, of similar size, or with its own historical PE to determine if the stock is under or overvalued.

A vital attribute of this ratio is that it standardizes the stocks of varying prices and earnings.

Should the P/E be high or low?

A comparatively high P/E ratio indicates that the firm is either overvalued or is on a path of high growth. Alternatively, it could also be an indication of the expectations of increased revenues in the future as this speculation has resulted in a demand that causes the upmove in its current price. Likewise, a low P/E ratio denotes the undervaluation of the stock or an indication of the poor performance of the company in the future, due to which, its stock prices might be falling. A low P/E ratio is perceived as an indication that the stock is having a cheaper current price and is expected to generate higher returns in the subsequent period.

Types of P/E

There are two variations of this ratio – the trailing P/E ratio and the forward P/E ratio. The former uses the earnings of the past 12 months and provides a relatively more accurate view of the stock’s performance while, the latter uses the expected earnings for the next 12 months and is based on an estimate of the futures earnings.

As per the current Nifty PE ratio chart (on September 8, 2020), Nifty PE ratio is 32.66.

Nifty 50 PE Ratio Monthly Chart