Imagine you are buying a product or a service. Do you want to pay extra from a reasonable price? Absolutely not right? When you are buying a product you can easily find the reasonable price of that product by comparing it with the price that other retailers are offering you. But when it comes to buying a stock finding a reasonable value of that stock is quite difficult. Everyone will give you the advice of checking the PE ratio whether he is your friend or your consultant. But can you buy a stock just by seeing its ratios? Is that enough? Let's find out the answer to this question. In this article, we are going to discuss what is PE ratio and how this ratio help you to find whether the stock price is cheap or expensive.
What is the PE ratio (Price to Earnings Ratio)?
PE Ratio (Price to Earnings Ratio) is the ratio of the current price of the stock of a particular company to its earnings per share (EPS).
PE Ratio = (Current market price of a share/Earning per share)
PE Ratio is used by the investors or analysts as an indicator to find out whether a stock is available at a cheaper or expensive price. The PE Ratio is also called as earnings multiple.
Suppose a company ABC stock price is currently trading at Rs. 100 and the Earning per Share of the company is Rs. 10. Then, the PE Ratio of the stock will be (100/10) 10 which means to earn one rupee from that company we have to invest 10 rupees.
It is the most common metric which is used all over the world by the analysts and investors to find whether the stock is available at a higher or lower price from its reasonable price. It also indicates that how much amount the investor has to invest to earn a single rupee from that particular stock.
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Types of the PE Ratio;
1. The forward PE Ratio
The forward PE ratio is all about how the company will perform in the future. In the usual calculation, investors or analysts use the last four quarters EPS (Earnings per share) to calculate the PE ratio. Whereas in the forward PE ratio the next four quarters estimated EPS is used to calculate the forward PE ratio. The forward PE ratio is considered more relevant than the historical PE ratio while analyzing a stock.
The limitation of the forward PE ratio is that the earnings per share used to calculate is inaccurate and estimated. If the earnings of the company will go up or down than our expectations then we may see a change in the PE ratio too.
2. The trailing PE Ratio
It is the most common metric used by investors and analysts while analyzing the stock. Whereas the Forward PE ratio gives us an inaccurate PE ratio the trailing PE ratio gives us an accurate PE ratio as it is totally based on the last four quarterly earnings of the company.
The formula for calculating the trailing PE ratio is the current price of the stock divided by the earnings per share for the last four quarters.
Trailing PE Ratio = (Current price of the stock/EPS for the last four quarters)
Whereas the trailing PE ratio gives you accurate measurements, there are some limitations also it can give you the current PE ratio of the company but you can't find whether the company will perform well or not. A company is performing and performed well in the past doesn't mean that the company will also perform well in the future.
How the PE ratio can be used to calculate the valuation of the stock?
Whereas the PE ratio is the most common metric used by the investors, it is also the most misused thing while analyzing the stock. There can be two ways we can use the PE ratio;
1. Compare it with other companies
To find out whether the stock price is high or low you can compare the PE ratio of the company with the PE ratios of other companies in the same industry or you can also compare it with the average PE ratio of the same industry. For example, if you are calculating the valuation of Ashok Leyland you can compare the PE ratio of Ashok Leyland with the PE ratio of Tata Motors you can't compare it with the PE ratio of Marico as it is from other industry.
Let suppose the PE ratio of Ashok Leyland is 20 and when you have compared with the PE ratio of Maruti Suzuki you see that the PE ratio of Maruti Suzuki's stock is 25. Then what does it mean? The first thing which comes to our mind is that Ashok Leyland's stock is available at a cheaper price than the Maruti Suzuki. If you are also thinking like this then you are wrong my friend. A lower PE ratio than the competitor doesn't mean that the stock is available at a cheaper price. Maybe the growth of the Maruti Suzuki is higher than the Ashok Leyland that's why the market is offering high PE. So, while comparing it from its competitor you should also check their growth in earnings and revenue.
Note; All the PE ratio are taken as example they are not relevant with the current PE ratio of the particular stock.
2 You can compare the PE ratio of a stock with its own PE ratio in the last few years
Comparing the PE ratio of a stock with its own PE ratio in the last few years will give you an idea whether the stock is available at a reasonable price or not. You can compare the PE ratio with the average of the last 5 years or 10 years. Suppose you are comparing it with the average PE of the last 5 years and the average is calculated as 20 and the current PE of the stock is 26 then, maybe the stock price is overvalued. And, if the current PE is lower than the average of a particular period then, maybe the stock is undervalued, and its a good time to invest. But it's not every time that the stock which has a lower PE than its own PE in the last few years is a good one to invest. Maybe the company is not performing well that's why the market is offering a lower PE. So, you need to analyze the stock on every parameter.
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Absolute PE ratio
In the Absolute PE ratio, the nominator is the current price of the stock, and the denominator is the trailing earnings per share either of the last 12 months or the estimated EPS of the next 12 months or it can be two past quarters and estimated EPS of next two quarters.
Relative PE ratio
In relative PE ratio, the nominator is the current price of the stock and the denominator is the Earnings per share of a relevant period like 5 years, 10 years, 2 years, or whatever the period with which you want to compare the current PE.
Reasons for a high PE ratio
A company has a high PE ratio, there could be some reasons behind that. These are the most common reasons for having a high PE.
1. Growth
Growth in earnings and revenue would be a reason behind the high PE ratio of a stock. Maybe the profit and revenue of the stock is growing rapidly per year that's why the market is offering a high PE ratio.
2. Overvalued
Maybe a huge no. of investors started to invest in a stock because of some good news or due to some changes in govt. policies reason could be anything that result in a rise in the PE ratio of that stock. But most of the time this type of rising in PE is temporary.
3. Future Prospect
Maybe the future prospect of the company is looking good to the customer. The company which is not performed well in past years but it attracts the investors, the reason could be anything like the company will be getting some new projects to work or it would be anything.
Reasons for a low PE ratio
These are some common reasons if a company has a low PE ratio;
1. Growth
One reason for having a low PE ratio is that maybe the revenue and the profit of the company is decreasing with time or the company is not performing well as past performance.
2. Undervalued
Sometimes a fall down in the economy results in a fall in the PE ratio of a stock which has even good fundamentals, generating good revenue and profits. So, when a stock has a low PE ratio without any specific reason it is said to be undervalued stock and that will be a good time to invest for you.
3. Future prospect
Maybe the company is performing well generating good revenue and profit but still, the company has a low PE. The reason behind could be that the investors don't have trust that if the company will be performing well in the future or not.
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Expectations vs. Reality
The company has a high PE ratio which means it will gonna perform well in the future that's why the market is offering it a high PE but not every time. It doesn't every time sometimes it can be overvalued.
The company has a low PE ratio so it is a good time to invest as it is available at a cheaper price but it's not every time that the stock having a low PE ratio is good to invest may be the fundamentals of the company are not good or performance over a period is not good that's why the market is offering it a lower PE.
Also read ; Investing Expectations vs. Reality
Conclusion
In the end PE ratio is just a part of stock analyzing. You can't invest in a stock by just considering the low PE ratio then benchmark. You have to check the other parameters as well like revenue, cashflow, profit, debt, etc. If you have any query please feel free to ask, you can comment down or mail us by filling the contact form. We will be happy to help you.
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