Price-to-Earnings Ratio (P/E Ratio)

About P/E ratio

The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock
price and EPS. It is a popular ratio that gives investors a better sense of the value of
the company. The P/E ratio shows the expectations of the market and is the price
you must pay per unit of current earnings.
Earnings are important when valuing a company’s stock because investors want to
know how profitable a company is and how profitable it will be in the future.
Furthermore, if the company doesn’t grow and the current level of earnings remains
constant, the P/E can be interpreted as the number of years it will take for the
company to pay back the amount paid for each share.

P/E ratio in use

• Compare a company’s financial performance with that of others in the same business.

• Compare a company’s financial performance with its past performance.

• Compare a benchmark index’s performance with its past performance.

PE ratio formula

P/E= 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒎𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆 /𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

For example, the market price of a share of the Company ABC is Rs 900 and the
earnings per share are Rs 90.
P/E = 900
90
= 10.
Now, it can be seen that the P/E ratio of ABC Ltd. is 10, which means that investors
are willing to pay Rs 10 for every rupee of company earnings.

What does P/E ratio tell about a stock?

High P/E ratio

Companies that have a higher P/E ratio are considered as a growth stock. If the
company has a higher P/E ratio, investors will have higher expectations from a
company with a higher earnings growth perspective and will show a willingness to
pay more as it shows a positive growth performance. But this attitude put a lot of
pressure on companies to perform at the investors’ expectation levels and want to
justify their higher valuation. In some cases, it can also be referred to as an
overpriced stock.

Low P/E ratio

Companies with a lower P/E ratio are considered as a value stock. That means the
company’s stock is undervalued. Investors look at these stocks as an opportunity.
These stocks tempt investors to invest in stocks before the market corrects their
value.

Negative P/E ratio

Sometimes companies that is losing money or with negative earnings having a
negative P/E ratio. That’s why; Companies that consistently show a negative P/E ratio
are not generating sufficient profit and run the risk of bankruptcy.

Conclusion

A price-to-earnings ratio, or P/E ratio, is the measure of a company’s stock price in
relation to its earnings.
Simply put, if the PE ratio of a company is 10, that means that for every 1 Rupee the
company makes, the investors are willing to pay 10 Rupees.
Even though, PE ratio is a good indicator of whether or not a company is over or
undervalued, no single ratio can tell the complete story about company’s financial
well-being. It is important to not look at the PE ratio in isolation and make a
judgement.