While investing in the stock market, PE Ratio can be a very helpful financial tool as it helps to determine the comparative value of the stock of a company on the basis of the company’s share price and projected future earnings. It helps the investors to make an apples to apples comparison between two stocks of two different companies and make the right investment decision for them. A high PE Ratio suggests the positive growth of the company whereas a low PE Ratio suggests that the stock price is undervalued. PE Ratio is an easy tool and can be used widely to make better financial decisions.
What is P/E ratio?
The price-to-earnings ratio is the ratio for valuing a company on the basis of its current share price relative to its earnings per share. It is also known as the price multiple or the earnings multiple. P/E ratio is used to compare a company against its own historical record or to compare aggregate markets against one another or over time.
P/E Ratio in Use
The P/E ratio helps in standardizing stocks of different prices and earnings levels. It gives the investors insights if the stock of a company is overvalued or undervalued as compared to its earnings. The ratio measures the amount of money the market is willing to pay for its current state as well as prospective growth of the company. For example- If a company is trading at a high P/E ratio, the market thinks highly of its growth potential and is willing to spend more based on future earnings.
High P/E Ratio
Companies which have a high PE Ratio are often taken as growth stocks. This indicates a positive future performance, and investors have higher expectations of future earnings growth and are willing to pay more for them.
The limitations to high PE Ratio is that the growth stocks are often higher in volatility, and this puts a lot of pressure on companies to do more to justify their higher valuation. Because of this, investing in growth stocks is seen as a risky investment. Stocks with high P/E ratios are considered to be overvalued.
Low P/E
Companies with a low Price Earnings Ratio are often taken to be value stocks. It means they are undervalued because their stock prices trade lower relative to their valuation. This pricing can be a great bargain and will prompt investors to buy the stock. And when the market corrects it, investors make a profit as a result of a higher stock price.
Types of P/E Ratios
P/E ratio can be calculated on a trailing/ backward-looking or forward /projected basis based on EPS that comes in two main options. Trailing EPS number signals the company’s performance over the past 12 months. The forward EPS is found in a company’s earnings release, which often predicts what it expects to earn in the future.
P/E Ratio Formula and Calculation
The formula and calculation used for this process are as under-
P/E Ratio =Market value per share / Earnings per share
To determine the P/E ratio, one must just divide the current price of the stock by the earnings per share (EPS).
Example of the P/E Ratio
As an example, let’s calculate the P/E ratio for Walmart Inc.
As of Feb 3, 2021, when the company’s stock price closed at $139.55.2 The company’s earnings per share for the fiscal year ending Jan. 31, 2021, was $4.75, according to The Wall Street Journal
Therefore, Walmart’s P/E ratio is $139.55 / $4.75 = 29.38.
How to Use PE Ratios for Stock Market Investing?
The price-to-earnings ratio, or pe ratio, is the most common way to value a stock. It’s also one of the concepts in finance that’s hardest to understand.
There are pe ratios for individual companies and the market as a whole. The pe ratio for a company is usually written as price/earnings or p/e. For the market as a whole, it’s written as price/earnings-to-growth, or p/eg (though you’ll also see it written pe/e.g.).
It works by taking the company’s stock price and dividing by its earnings per share (EPS), then multiplying by some growth rate. The result tells you how much you need to grow your earnings every year to justify the current stock price. If you don’t think the company will grow that fast, you should wait until it does before buying its stock.
The best time to determine whether to buy or sell is when the stock gets close to its 52-week high.
The price/earnings ratio is an economic measure of the relationship between the price of a share of stock and the earnings per share. It is calculated by dividing the current market price of a share by its earnings per share.
Limitations of Price Earnings Ratio
Finding the correct value of a stock cannot just be calculated using current year earnings. The value depends on all expected cash flows and earnings of a company in the future. PE Ratio is useful as it gives some understanding of the growth prospects in EPS and risk profile of the company. An investor must deeply study the company’s financial statements and use other methods for valuation to get a better picture of a company’s value and performance.
Additionally, the Price Earnings Ratio can produce misleading results as when Negative EPS resulting from a loss in earnings will produce a negative P/E. An exceedingly high P/E can be generated by a company with close to zero net income, resulting in a very low EPS in the decimals.
Conclusion
So, PE Ratio is a very important financial term. It denotes the relative price of a stock of a company compared to its competitors. Understanding PE Ratio can facilitate your investment decisions.
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