Understanding P/E Ratio

The price to earnings (P/E) multiple or ratio is probably the most popular indicator used by investors for valuing stocks. It is the ratio of a company’s stock price to its earnings per share.

The price to earnings (P/E) multiple or ratio is probably the most popular indicator used by investors for valuing stocks. It is the ratio of a company’s stock price to its earnings per share. (Earnings per share or EPS is a company’s net profit divided by the number of shares it has issued.) Another way of looking at the P/E ratio is as a ratio of the value that the market thinks a company deserves to its net profit.

What does P/E ratio mean?

It tells you how to cheap or expensive a company’s stock is. It is the number of times investors must pay for the company’s current earnings. For example, assume that the share price of a company is Rs.120. If its EPS is, say Rs 5, its P/E is 24. So investors are willing to pay 24 times for every rupee of the company’s earnings.

What is the use of P/E ratio to me?

Since you can use the P/E ratio to figure out if a company’s stock is cheap or expensive, you can compare the stock price of one company with that of another company in the same industry, or stocks of two companies from different industries. You can have a P/E ratio for an industry as well as a stock group, like the BSE Sensex or the NSE Nifty.

Does P/E ratio have any limitations?

It is a good guide but it is not a watertight indicator. The P/E published in a newspaper is for the previous year. But stock prices move because of investors’ future expectations. A company with an admirable P/E in one year may post a loss the next year and there will be no P/E left, since earnings disappear.

Even if two companies have the same P/Es in the same industry, they may not be equally cheap or expensive. You will need to know which company will have a better earnings growth next year to evaluate one against the other.

The major number entering the P/E ratio from the profit and loss statement is net profit. Some companies are known to inflate profit figures. For example, earnings under the head called ‘other income’ which could be by way of selling assets (and hence non-business income) can play spoilsport and result in a misleadingly low P/E to lure gullible investors. Lower expenses than the actuals can also inflate the net profit number and hence distort the P/E.

What is forward P/E?

Analysts use a measure called forward P/E based on their net profit forecasts for the next few years, but this number is not easily available to all. Forward P/E has the expectation of analysts built into it. The better the analysts’ forecasts of profits, the closer will be the forward P/E to the actual number.

Analysts use forward P/E Ratio as a key to predict the price movement of a stock in the market. As is said most frequently, the stock market discount future earning estimates of a company and adjust the valuation of its stock accordingly.