PE Ratio: What Is Price To Earnings Ratio In The Share Market?

The price-to-earnings ratio in the share market, or PE ratio, is the ratio of the current market price of a company’s share to the company’s earnings per share (EPS). It is one of the most widely used metrics to evaluate stocks. In this article, we will explore the meaning of PE ratio, its types and how it can help you make investment decisions.

The PE ratio of a company is essentially the amount of money an investor will invest in a single stock of the company for ₹1 of its earnings. The formula to calculate a company’s price-to-earnings ratio is:

PE Ratio = (Current Share Price / Earnings Per Share)

For example, if a company has a PE Ratio of 30, this means that the investors are willing to pay ₹30 in the company’s share for ₹1 of its current earnings.

A high PE ratio suggests that the company is either overvalued or is on a growth trajectory and is expected to increase its revenue in the future.

On the other hand, a low PE ratio means that the shares of the company are undervalued due to certain risks associated with it. It may also mean that the company is not expected to perform well in the future.

Primarily, investors take two types of PE ratios into consideration- forward PE ratio and trailing PE ratio. Both of these types depend on the nature of earnings.

• Forward PE Ratio

  The forward PE ratio of a company is calculated by dividing the current market price of a single stock of the company by its estimated earnings. This estimate is taken from the company’s future earnings guidance. Since this ratio takes the company’s future earnings into account, it is also called the estimated PE ratio. Investors and market analysts use the forward PE ratio to evaluate a company’s future performance and its estimated rate of growth.

• Trailing PE Ratio

  The trailing PE ratio considers the past earnings of a company. This is the most widely used evaluating metric used by investors as it gives a more accurate idea of a company’s performance over a period of time.

Apart from forward and trailing PE ratios, there are two more types of PE ratios that are used to gauge a company’s performance- absolute PE ratio and relative PE ratio.

• Absolute PE Ratio

  This is the traditional way of calculating PE ratio where the current market price of the stock is considered along with the past or future earnings of the company. Both forward and trailing PE ratios are absolute ratios.

• Relative PE Ratio

  Here, the company’s absolute PE ratio is compared to a benchmark PE ratio or the past PE ratios of relative companies. The relative PE ratio is used to check how a company is performing compared to its past performance or its benchmark ratios.

Shares of companies of different sectors trade in different PE ranges. Hence, a single price-to-earnings level cannot be used to evaluate all stocks. You must consider a company’s historical PE ratios and check if the current PE ratio is close to the higher end of the range or to the lower end. If it is trading close to the lower end, it can be considered a good investment opportunity.

While the PE ratio is a great metric for comparing various stocks from the same industry, it must not be the only factor to be considered while investing. You must study the companies carefully and understand their operations and finances before investing in their shares.