Here’s the most popular valuation metric that every investor must know; take a look!
Valuation metrics are ratios and models that can give investors an idea of what a company may be worth.
The price-to-earnings ratio (PE ratio) is one of the most popular valuation metrics used by investors and analysts to determine the relative value of a company's shares. It is useful in making investment decisions. A company’s PE ratio can be compared against its own historical record or the industry PE. The ratio indicates whether a stock is overvalued or undervalued at its current price. A high PE ratio suggests that the stock is overvalued or that investors expect high growth rates in the future. The beauty of the PE ratio is that it standardises stocks of different prices and earnings levels, permitting for an apples-to-apples comparison.
There are several different types of PE ratios used in practice. PE ratio may be estimated on a trailing (backward-looking), forward (projected), or average basis. Trailing twelve months (TTM) PE is calculated as the current share price divided by the earnings over the past 12 months i.e. last four quarterly EPS. TTM PE is more optimal relative to an individual’s earnings estimates. TTM PE also furnishes an insight into whether the overall market or index is too high or low in comparison to the past PE ratios. However, a key limitation of the trailing PE ratio is that it doesn’t take into account a company’s future earning potential. TTM PE is dynamic as the price of a company’s stock changes every trading day while earnings are only declared each quarter.
Thenceforward, the PE ratio is also considered by investors. Forward PE is calculated as the current share price divided by estimated future earnings based on the guidance received from the company's management or analysts. Forward PE evinces a distinct idea of a company’s future earnings, which is more relevant than trailing PE because past earnings tend to be discounted in the current share price. A drawback of forward PE is that it is easily prone to deliberate misestimating either by the company’s management or analysts. If a company’s forward PE ratio is lower than the trailing PE ratio, then analysts expect earnings to increase and vice-versa.