P/E Ratio – The Definition
P/E Ratio or PE Ratio as they are commonly referred to stand for the Price to Earnings Ratio of a company.
In simple terms it helps an investor calculate the price multiple that investors are willing to pay for a company’s earnings.
Watch this video to understand the pe ratio
PE Ratio Formula
P/E Ratio of a Stock = Current Market Price of the stock/Earnings per share
The current market price of the stock can be obtained from the stock exchanges where the stock is listed.
The Earnings per share used in the denominator can be of 2 kinds
- Trailing EPS used to calculate trailing P/E multiple – The actual reported earning per share of the company for the immediately preceding financial year i.e. for 12 months trailing. You can find the trailing PE ratio of the company from the SAMCO Data Bank available in the SAMCO Back Office – SAMCO STAR.
- Forward EPS used to calculate forward P/E multiple – The forecasted earning per share of the company for the next immediate financial year i.e. for 12 months forward
When the price of a stock is INR 20 and the EPS is INR 2, PE works out to 10. The price-earnings ratio tells that the investor willing to pay INR 20 for earning INR 2.
PE Ratio Interpretation
In value investing, ‘value is what you get and price is what you pay.’ Value is nothing but the differential between current price and fair value of the stock.
In fundamental analysis, to derive at fair value analysts use various methods and ratios. P/E is one of the most important and interesting ratios used to compare the price and value of a particular stock.
Usually higher the P/E ratio, the more premium is the stock and vice versa. A high P/E ratio doesn’t necessarily mean that a stock is expensive and should be sold. It simply means that investors are willing to pay a premium to hold the stock. This premium may be due to a variety of factors.
In simple terms, its a valuation tool used to determine whether the stock is being traded at the Exchange at a premium or a discount to the worth of the underlying value of the business.
PE Ratio Analysis
There are multiple reasons why a particular stock could be trading at a low PE multiple or a high PE multiple.
Factors that could contribute to a High P/E multiple include but are not limited to
- Superior Growth potential of the company
- Stable and Visible profitability of the company
- Superior Corporate Governance practices of a company
- Monopolistic nature of the business and industry leadership
- Efficient business models with efficient utilisation of assets
Factors that could contribute to a Low P/E multiple include but are not limited to
- Lack of visibility of earnings of a company
- Poor corporate governance practices and lack of management credibility
- Low growth potential or de-growth prospects of the company
While an investor conducts PE analysis and tries to determine if a company is cheap or expensive, the following questions must be asked
- Is the PE Ratio of the company similar to its industry peers i.e. compare the stock’s P/E and industry PE?
- Is the PE Ratio of the company in a range as compared to its own historic PE Ratio i.e compare the stock’s P/E and its own historical PE?
- Is the PE Ratio of the company similar to its global peers i.e. stock’s PE in comparison to global industry peers?
Usually a stock’s PE ratio should move in line with its own industry and global peers. It also usually moves in a rangebound fashion to its own historic PE multiples. Any major divergence from these should require additional investigation on why is there a divergence in the PE ratio from the above. Investors should be able to explain/justify this divergence and subsequently take an investment call.
PE Ratio by Industry
Similar to the PE Ratio for a stock, an investor should also evaluate the PE Ratio of the Industry.
PE Ratio by Industry = Current Market price of the Sectoral Index/Weighted Average Earnings per share of the stocks comprising of the index.
As explained above, once the PE ratio of the industry is computed and calculated, it should be compared with the PE ratios of the individual stocks of the same industry. This can act as a great reference point to interpret the premium or discount of a particular stock.
While the PE Ratio works as for analysis across various industries, however there are certain sectors where the PE has limited application and other valuation methods are preferred over the PE Ratio.
- Banking – P/B Ratio is preferred over the P/E Ratio
- Manufacturing/Commodity and Asset Heavy Businesses – EV/EBITDA is used in combination with the P/E Ratio
- Holding Companies – Net Asset Value basis
In the purest form, the true value of a company is the sum of the discounted present values of all future cash flows. This is often computed using the Discounted Cash Flow method which is extremely difficult and cumbersome. The PE Ratio is an extremely simplified valuation methodology. While the PE Ratio is widely used for its simplicity, it cannot be relied upon as the only valuation methodology. It must be used in combination with other valuation methodologies to arrive at more accurate and conclusive valuation in the process of fundamental analysis.