What is PE Ratio?

Price to Earnings Ratio or Price to Earnings Multiple is the ratio of share price of a stock to its earnings per share (EPS). PE ratio is one of the most popular valuation metric of stocks. It provides indication whether a stock at its current market price is expensive or cheap. Let us explore what is PE ratio, its different types and how to use them in investment decisions.

Significance of PE ratio

What does PE ratio mean?

The earnings of stock (EPS) can either be distributed to shareholders as dividends or re-invested in the business to grow revenues and EPS in the future leading to capital appreciation. PE ratio is the price investors are willing to pay for Rs 1 of EPS of the company. If earnings are expected to grow in the future, the share price goes up and vice versa. If the share price grows much faster than the earnings growth then PE ratio becomes high. If the share price falls much faster than earnings, the PE ratio becomes low. A high PE ratio means that a stock is expensive and its price may fall in the future. A low PE ratio means that a stock is cheap and its price may rise in the future. The PE ratio, therefore, is very useful in making investment decisions.

Types of PE ratios

We discussed what is PE ratio? Let us see their types -

• Trailing Twelve Months (TTM) PE: TTM PE is the current share price divided by the last 4 quarterly EPS. TTM PE is easy to calculate because companies declare the financial results including EPS every quarter.
• Forward PE: Forward PE is the current share price divided by the projected EPS over the next 4 quarters. Calculating forward PE requires expertise because it involves forecasting sales, margins, P&L and EPS. Research analysts estimate forward earnings and PE ratios based on guidance received from company management and their own research.

Forward PE is more relevant than TTM PE because past earnings (EPS) are already discounted in share prices whereas forward earnings can provide indications of future stock price changes. That said, time series analysis of TTM PE can also provide useful insights into whether a stock price is getting overheated. TTM PE can also provide insight into whether the overall market or market index is too high or low when compared to past PEs.

Absolute PE versus Relative PE

• Absolute PE: The PE ratios calculated by using any of the two methods described above i.e. TTM PE or Forward PE is known as absolute PE. This is most widely quoted PE ratio in media. However, absolute PE ratio by itself has some limitations. The most major limitation of absolute PE is that stocks in different industry sectors trade in different valuation ranges. For example, PE ratios of metal stocks are usually much lower than PE ratios of FMCG stocks, but this does not mean that metal stocks are cheaper than FMCG stocks and therefore, more attractive. This limitation of absolute PE is overcome by using relative PE.
• Relative PE: Relative PE compares the current absolute PE to a range of past PEs over a relevant time period, such as the last 10 years. Relative PE usually compares the current PE value to the highest value of the range. For example, if the highest PE ratio of a stock in the last 10 years was 30 and the stock is currently trading at a PE of 27, then its relative PE will be 0.9.

What is a good PE ratio?

As mentioned earlier, stocks in different sectors trade in different valuation (PE) ranges. Usually stocks with higher earnings growth potential have higher PE ratios. Therefore, we cannot use a single PE level across all stocks to infer whether the price is attractive or not. You should look at historical PEs of a stock and see if the current PE is near the higher end of the range or near the lower end of the range. If the stock is trading near the lower end of the range then it can be a good investment opportunity subject to other factors which we will discuss later.

As far as Nifty is concerned, it has traded in a PE range of 10 to 30 historically. Average PE of Nifty in the last 20 years was around 20.* So PEs below 20 may provide good investment opportunities; lower the PE below 20, more attractive the investment potential.

Conclusion

In this article, we discussed what is PE ratio, what is good PE ratio, its different types and how it is used in investment strategies and its limitations. PE ratio is a great metric for stock and index valuation, but mutual fund managers use it in conjunction with various other decision factors like sustainable business model evaluation, competitive advantage, market share growth potential, earnings growth prospects, low to moderate debt equity ratio and strong management team.

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