Article

PE Ratio in Stock Market Trading

date 18  July,  2023
time 13 mins read

Overview

Contrary to popular belief, stock market investment involves more than merely buying stock in firms and anticipating its appreciation over time. Stock market investments require extensive research regarding the financial position of the business or industry growth, etc. The financial metrics of a business offers a lot of information & necessary insights that could assist an investor in deciding whether or not to invest their money in the business. As an investor, have you ever wondered how brilliant investors forecast a company’s worth or identify a multi-bagger stock? The truth is when they purchase stocks underpinned by thorough financial research, to consider several factors, such as financial stability and promising future growth possibilities. In this post, we’ll look at what does PE ratio mean, how it should be computed, types of PE ratios, and how significant it is for stock market trading and investing purposes-

PE Ratio- Meaning and Purpose

Profit Earnings Ratio or PE Ratio is a financial metric based on a company’s current market share price concerning its earnings per share or EPS. The ratio is a crucial indicator that shows whether or not the market price of a certain stock is either undervalued or overvalued. In other words, PE is a financial metric that helps investors understand whether the market share trading price is reasonable enough given the expected profit growth rate.

Where the earnings of a business are declining faster than its current market share price, the PE ratio starts falling, whereas the share prices of a business are rising more rapidly than the earnings of the business, which signifies a rising or higher PE ratio. A lower PE ratio may suggest that a business is still undervalued and may rise in the future, whereas a stock with a higher PE ratio may indicate that its price may fall in the coming days. Therefore, investors use the PE ratio to understand whether a particular stock is either undervalued by comparing the ratio of a particular company with its industry peers or similar industry equities. Analysts sometimes prefer to value patterns that span a long time, such as the past 10- 30 years of earnings. Measures like P/E 10 or P/E 30 are relevant in this situation. Using metrics like the S&P 500, investors can examine the worth of the total stock index. Such long-term measurements provide a clearer overall picture of the changes in the business cycle.

While analysing any stock for investing or trading, analysts consider earnings from other periods when calculating this ratio, preferably the company’s earnings over the past year or the previous 12 months.

For instance- Raj and Jay launched a beauty supplies business where both partners invested an initial capital of Rs 20,000. Each of them gets 5000 shares of Rs 8 each.

  • The capital structure of the business includes- Total Capital=Rs 40,000
  • Total No of shares=Rs 10,000
  • Shareholder= 2

After one year, they have a successful business which generated a profit of Rs 40000. Accordingly, each shareholder receives 50% of the profit, up to Rs 20000. So, the earnings per share calculation shall be calculated as follows –

EPS = Earnings / No. of shares

= 20000 / 10000

= Rs 2

It gives the impression that both the partners are about their earnings on their owned 5000 shares. Now, as they know that they are earning a profit, Raj and Jay share success stories with their friends & families, and one of their friends, Harish, expresses interest in investing in their profitable business.

So, he comes to the partners and decides to buy 1000 shares at a cost of Rs 20 /share (he cannot buy at Rs 8 as the business is a success). Consequently, Harish added a premium of Rs 12 over the base rate of Rs 8 per share.

Then, the P/E ratio will be:

P/E = Price / EPS

= 20/2 = Rs 10

It also implies that Harish agrees to pay 10 times the market price for the shares to have a similar chance to profit as the current shareholders. P/E should therefore be 10x in this instance to reflect the shareholder’s willingness.

What Is the Formula to Calculate PE Ratio?

A share’s fair market value (FMV) or intrinsic value can be calculated by dividing the total value by the number of outstanding shares. The fair market value of a share is usually determined using this method, which attempts to calculate the asset’s intrinsic value based on future cash flows discounted at the risk-free rate.

Price to earnings (P/E) could be determined by dividing this market price per share by either –

  1. the company’s actual earnings per share or
  2. diluted earnings per share of the business (assuming outstanding warrants and options).

The formula for PE Ratio states-

P/E Ratio = Cost per share/current market price of a share

                                 Earnings Per Share (EPS)

Here, cost per share, also known as the price paid for acquiring one share of the company’s stock, is sometimes referred to as the share’s current market price. Similarly, one may calculate a company’s earnings per share by dividing its net profits by the total number of shares outstanding. In addition, it was simple to compute because the information about the stock’s current price and earnings per share was freely accessible on the company’s website and stock exchanges.

P/E Ratio- What Does It Indicate About a Stock? 

To determine whether a business is undervalued or overvalued, the P/E ratio should be compared with peers in the same industry that engage in similar business activities (of comparable size) or its historical P/E. Several industries have historically had low P/E ratios, such as those in the diamond and fertiliser industries, whereas industries such as FMCG, pharmaceuticals, and IT typically have higher P/E ratios. Following is an examination of various P/E ratios-

  • Higher P/E- If a company has a high price-to-earnings ratio, you might think about choosing its shares. Since it portends better future performance and has raised its expectations for future earnings growth, investors are more willing to pay more for them. However, the drawback of high P/E is that growth stocks are frequently unpredictable, which puts heavy pressure to perform better to support their higher valuation. Accordingly, investors should keep in mind that investing in growth stocks could be relatively riskier.
  • Negative P/E – A negative P/E ratio indicates a business has poor or no earnings. For instance, long-standing businesses can experience periods of negative cash flow brought on by external factors. However, if a company’s P/E ratio is continually negative, investors should steer clear of it as the organisation may fail. Some companies choose not to report EPS for particular quarters to avoid displaying a low P/E ratio.
  • Low P/E- Stocks of companies with a low price-to-earnings ratio are frequently believed to be undervalued. Low P/E ratios are frequently a sign of a company’s weak present and projected future performance. The risk of this investment is high. But only if the company’s fundamentals are solid must you purchase shares of the business. If you want to make money over the long term, you can invest in the stocks of inexpensive firms with solid fundamentals.
  • Justified P/E- Justified P/E is different from the ordinary P/E ratio and computed independently from the former, and both ratios offer different outcomes. If the P/E is less than the justifiable P/E ratio, the business share is cheaper, and buying the same could result in profits.

What are the various types of PE Ratios?

As we can see, numerous methods for calculating the price-to-earnings ratio exist. While some strategies use prior reported data, others entail anticipating future paths. Each method has its use, and its suitability will differ from one industry to the other. Provided below are the types of PE ratios for investors to be aware of-

  • Forward Earnings – In this sub-type of price-to-earnings ratio, investors utilise the expected future earnings of a business to assess its share price. This ratio can be calculated by dividing the stock’s current market price by its anticipated profits per share for the subsequent four quarters. Forecasting sales, profit margins, and earnings per share make it challenging. Participants determine this ratio by a thorough analysis of the available data.
  • Trailing Twelve-Month Earnings – The PE ratio is calculated using a company’s profits over the previous 12 months, also referred to as “trailing twelve-month earnings” or “TTM earnings.” employing actual reported data is one of the key benefits of employing this ratio. Accordingly, this method is more dependable and easier to calculate.
  • Shriller PE Ratio- Shriller PE ratio, or cyclically adjusted price-to-earnings ratio (CAPE), is the ratio that considers a business’s weighted earnings over a certain period. To calculate the shriller PE ratio, the price of the stock shall be divided by the moving average of the average of ten years of earnings after being adjusted for inflation. As a valuation metric, it shows the multiple that the current price of a stock or index trades over its inflation-adjusted over ten years adjusted earnings.

How to compare P/E ratios for different businesses for stock trading? 

The following are some of the considerations to be made when comparing the PE ratios of various businesses-

  • Industry Peers- Competitors in a given industry typically operate under comparable financial structures. P/E ratios for companies in the same sector should therefore be similar, and positive variations probably indicate the company’s strength or potential for expansion. Buying stocks of a business with the belief that the business has growth potential with a lower P/E ratio.
  • History- Another of the best strategies to consider for purchasing stocks with continually low P/E ratios is to consider the history of the PE ratio of the stock. Looking for any specific factors that may cause a stock to trade at higher prices in the future or the reason for the P/E ratio has been adverse for a few years. Further, where the growth of any given stock’s PE ratio reaches the highest despite the growth rate slowing down, the stock price may decline shortly. Suppose a company is in the initial stages of its life cycle and continues to validate its business model. In that case, investors can expect several expansions in the future years and may be prepared to accept a high P/E ratio. If a company has a history of slower or no development, be aware of repeated contractions and only accept low P/E ratios.
  • Business Growth- You can compare ratios by figuring out a firm’s P/E ratio as a multiple of the predicted earnings growth rate because a company growing quickly may be worth a high P/E ratio. Divide the P/E ratio of a company by either the earnings growth rate over the previous few years or a forecast provided by an analyst for the following few years. Companies having modest P/E-to-earnings-growth (PEG) ratios may be worth slightly higher P/E ratios.

Benefits of PE Ratio

  • Valuable Metric for Comparison Against Other Stocks– The PE ratio is an effective tool for assessing the value that different equities are worth against each other. For instance, if an investor wishes to purchase a bank stock and you are choosing between Bank ANC and Bank of XYZ, you might choose the one with the lower PE ratio. Though both banks are great businesses with very similar business models, it is only more logical to purchase the stock of one business over the other if you can do it for less money.
  • Widely in Use- The PE ratio is the most referred to valuation metric in finance. It has become the industry standard for almost every publicly traded stock worldwide, making it possible for investors to follow up on any public company’s PE ratio.
  • Benchmark for Determining Value– The PE ratio is a great tool for comparing a stock’s worth to the index as a whole. For example, company P’s PE ratio is 19 compared to the average PE ratio of 14 for the past 20 years. Compared to the historical average, a PE ratio of 14 may be deemed undervalued today.
  • Helps in Decision Making- Investors who spend their entire lives searching for undervalued stocks to buy want an efficient method of navigating through the numerous stocks they are exposed to. The PE ratio is an excellent approach to eliminate overvalued stocks and even get a list of potentially undervalued business stocks. And to accomplish this in a matter of minutes, a stock filter is an excellent tool.
  • Easier to Calculate- The PE ratio can be simply determined if a company’s stock price and earnings per share are known. It offers a highly convenient method for promptly valuing a stock.
  • Utilised to Assess the Growth Potential of a Business- To purchase stocks, value investors frequently search for exceptional businesses with low PE ratios. A low PE ratio may indicate that the market undervalues the stock, and it is just a matter of time until other investors discover the undervalued potential. Price increases follow from this discovery. On the other side, stocks with extremely high PE ratios frequently generate lower returns.
  • It can be Applied to Figure out a Stock’s Price– The PE ratio is the most efficient way to quickly calculate the value you receive in return for the amount of money you pay. The idea is to buy a deal to boost the possibility of better returns. Paying too much lessens the likelihood of this.

Limitations of PE Ratio

Although the P/E ratio is a helpful and appreciated measure in the valuation of companies, it cannot be relied on as a stand-alone criterion. When combined with additional valuation techniques, it could offer a clearer picture. Provided below are some of the key limitations of the P/E ratio-

  • Reflects only Past Earnings- Earnings per share, a historical metric from either the most recent quarter or the previous year, are used to determine the PE ratio. The PE ratio does not reflect a company’s current value or forecast future value.
  • Open to Manipulations- The PE ratio’s major flaw is that it is susceptible to manipulation and should not be taken at face value. As an illustration, a business might sell assets and report the proceeds as revenue, artificially inflating the company’s earnings.
  • Does not take into Account Corporate Debt– A company’s low PE ratio may make it appear appealing on the surface. However, the balance sheet information is not included in the PE ratio. The business may be heavily indebted and on the edge of bankruptcy.
  • Cannot be Employed to Determine Business Debt- In case a business is losing money but also doesn’t have any earnings, it becomes difficult to determine the PE ratio for such a business. For example, in its early years, Tesla didn’t generate any earnings, but at the same time, it kept growing with higher demand.
  • Subjective in Nature– what a single investor may consider a good deal may be overvalued for another. Both an art and a science, investing is a complex endeavour. Predicting management’s performance, where earnings will go, and the competitive landscape is necessary when buying a stock.
  • Could be Impacted Easily by Various Accounting Methods- The PE ratio of a corporation can be impacted by several accounting techniques. In contrast to a First In, First Out (FIFO) accounting technique, a business could opt for a Last In, First Out (LIFO) accounting method, which records the most recently manufactured things as sold first. The most recently produced items cost more during periods of rising prices; as a result, LIFO results in decreased earnings. Furthermore, R&D expenses are instantly deducted from earnings, which suggests that earnings are lower. Technically, investing money in research & development is a long-term investment. These businesses, like Amazon’s higher expenses on R&D, have led to its unusually higher PE ratio.

Difference Between Absolute P/E ratio vs Relative P/E Ratio

  • Absolute PE- The PE ratios determined through either the TTM PE or Forward PE methods are referred to as absolute PE. However, using the absolute PE ratio alone has some drawbacks, and one of the biggest drawbacks of absolute PE is that businesses in several industrial sectors trade at an assortment of valuation levels. For instance, the P/E ratio of metal businesses is usually lower than the P/E ratio of FMCG businesses, but this doesn’t imply that the metal stocks are more affordable & thus more desirable than the latter. With the use of relative PE, one could eliminate the drawbacks of Absolute PE.
  • Relative PE- Relative PE analyses the current absolute PE with a range of prior absolute P/E over a certain period (say ten years). Generally, relative PE draws a comparison between the current PE value and the highest value in the range. For instance, the relative P/E for a particular stock would be 0.7 if its maximum PE ratio during the previous ten years was 32 while it is presently trading at a PE of 28.

So, what is an ideal PE Ratio for any given stock?

As above-mentioned, it is only natural for investors to look for stocks with a higher P/E ratio, but the question about how much higher is better? The answer to this question relies on the investors if they are not considering all the factors responsible for the appreciation in share value. Due to this reason, a lot of stocks in the market are overvalued or sold for a premium. Therefore, an investor should also consider management quality rather than just the financials of a business before investing for good returns.

Furthermore, the other question which confuses a lot of investors is the good or ideal PE ratio to what is regarded as a good or safe ratio will determine where to invest. Every investor should keep in mind that the value of the PE ratio might differ based on an array of factors such as market conditions, average industry PE ratio, and the state of the industry as a whole, among others. While assessing different P/E ratios, investors should also educate themselves about similar businesses belonging to the same industry with comparable features with their stage of development. For instance, there are two comparable businesses C and E and both of the same industry. While C has a PE ratio of 30 and business E having comparable business models and operating within the same industry, has a PE ratio of 12. It shows that the shareholders of C shall pay Rs 30 for every rupee generated by the business, whereas the shareholders of E would be required to pay Rs 12 for every rupee generated in the business’s earnings. Hence, it might be profitable for a new investor to invest in Company E.

Low ratios could be a sign of a company performing below par due to internal problems, whilst high ratios are linked to the risk of value trap investments. As a result, there is no P/E ratio that investors can depend on to ensure their stock market investments are successful. Some other technical analysis indicators, including discounted cash flow, the weighted average cost of capital, and others, can be employed in this regard to determine a company’s probable profitability.

Conclusion

Therefore, the PE ratio is a crucial tool to appreciate the business and market conditions at any point in time. Investors and companies use it to make financial decisions and effectively value their stocks based on the share market Value and earnings to date or future earnings. As the PE ratio relies heavily on earnings per share of a business, it could be deceptive due to fluctuating stock prices or earnings. Businesses can declare good revenues despite producing negative free cash flow using various strategies. As it is impossible to accurately assess the investment suitability of a given stock, every investor needs to undertake thorough research and analysis of the stock’s performance using various financial tools & techniques, which could help investors make wise long-term investment decisions.

FAQs

  1. What is an ideal PE ratio? 

For a given stock, there may be several different valuation ranges. Comparing growth stocks to their value equivalents, growth stocks have a higher ratio. A positive price-to-earnings ratio is subjective and may vary from industry to industry. By evaluating historical PE values, you can decide on greater and lower bands for the same PE value. After that, calculate the current PE ratio, then check to see if it is close to the upper or lower band. Depending on other variables, a solid investment opportunity exists if this ratio is close to the lower end of the range.

  1. What distinguishes absolute PE from relative PE?

It is possible to calculate absolute PE ratios employing the forward or trailing 12 months method. However, a relative PE ratio can be determined by comparing the absolute value with an array of past historical price-to-equity ratios over a predetermined period.

  1. What is the limitation of absolute PE?

Because share prices of businesses operating in various industries can have a wide range of valuations, the PE ratio has a lot of limitations and can occasionally be deceiving. Even while an automaker’s PE may be lower than an FMCG maker’s, the former’s stock price is not necessarily inferior to the latter.

  1. What differentiates the PE and PB ratios?

Price to book, or PB ratio, is a financial metric that indicates how closely the market value of a business matches its book value. Whereas, Price to earnings ratio establishes the relationship between the earnings of a business to the stock market price.

  1. What is the difference between PE Ratio and the PEG Ratio? 

Price to Earnings (PE) and Price Earnings Growth ratio (PEG) ratio has many common features as they help investors understand the relationship between the stock price of a company and its earnings. However, both ratios differ in the fact that the PEG ratio factors in the expected growth rate of earnings, whereas the PE ratio doesn’t.

  1. What does it signify if the PE Ratio is negative?

A lower PE ratio indicates that the business is witnessing lower revenue earnings or losing money faster. Though, the most prominent businesses may occasionally go through downtimes, which may be due to business issues or sometimes factors outside the control of the business.

  1. Should investors consider purchasing stocks with higher PE ratios?

Though PE ratio is one of the most common indicators for valuing a business, where an undervalued stock will typically have a lower P/E ratio, whereas an overvalued stock of the business would generally have a higher PE ratio, hence, a stock with a lower P/E ratio may be more advantageous for investors.

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