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Chapter 7

The P/E ratio, or price-to-earnings ratio, is a key metric used by investors to assess the relationship between a company's current share price and its earnings per share. A high P/E ratio may indicate overvaluation or growth potential, while a low P/E ratio suggests undervaluation. Investors should compare P/E ratios with historical data and industry peers for better analysis, and consider factors like earnings stability, dividends, ROIC, and interest rates when evaluating stocks.

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4 views

Chapter 7

The P/E ratio, or price-to-earnings ratio, is a key metric used by investors to assess the relationship between a company's current share price and its earnings per share. A high P/E ratio may indicate overvaluation or growth potential, while a low P/E ratio suggests undervaluation. Investors should compare P/E ratios with historical data and industry peers for better analysis, and consider factors like earnings stability, dividends, ROIC, and interest rates when evaluating stocks.

Uploaded by

anir.dalui
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We take content rights seriously. If you suspect this is your content, claim it here.
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DEMOCRATIZING WEALTH CREATION

Module : 1 Chapter : 7

What is PE Ratio?
P/E Ratio
DEMOCRATIZING WEALTH CREATION

P/E ratio is generally considered as very useful by investors as it helps them to gauge what the market is willing to pay for the
company’s earnings. This ratio is very commonly used by investors while making investment choices. However, if you are
baffled by the vast amount of financial information and definitions of P/E ratio available online, don’t worry. We have tried our
best to simplify the information related to the P/E ratio for your easy understanding.

The price-to-earnings ratio, commonly known as the P/E ratio, is simply a ratio that throws light on the relationship between
the current share price and earnings per share (EPS). At times, this ratio is also known as the price multiple or the earnings
multiple. Usually, for the calculation of the P/E ratio, the amount of earnings of a company of the last 12 months or one year is
used.

Simply stated, the P/E ratio denotes the amount of money an investor is willing to pay for a single share of a company for Re
1 of its earnings. Hence, for example, if we consider a company having a P/E ratio of 23, it means that the investor is ready to
pay Rs 23 for Re 1 of the company’s earnings.

P/E ratio = current share price/earnings per share (EPS)


Now that we know what P/E ratio stands for, the next question that crops up is: ‘Can one invest based solely on the P/E ratio?’
Before jumping on to find the answer to this question, let us first find out what is the buzz about high or low P/E ratios.
Generally, a comparatively high P/E ratio indicates that a particular company is either overvalued or it is on a path of high
growth. It could also be an indication of the expectations of increased revenue in the future, and such a speculation can result
in a demand that causes the upmove in the stock’s price. On the other hand, a low P/E ratio denotes that the stock is underval-
ued. A low P/E ratio is often perceived as an indication that the stock is currently trading at a cheaper price and is expected to
generate higher returns in the future.

Now, as for the use of P/E ratio for investment purpose, one can say that there is considerable misuse of the PE ratio while
investing. Merely referring to the P/E of stocks while investing is surely not a good idea. The right method would be to use
this ratio to compare it with the company’s historical P/E or P/Es of its peers/competitors and to the P/E of the industry as a
whole. As such, it is not advisable to use this ratio in isolation as one cannot be sure if a stock with a certain P/E is a bargain
or it is expensive. Additionally, the P/E ratio varies for different sectors. Certain sectors like fertilizers or cyclical sectors tend
to have a low P/E ratio. The cyclical companies normally have high P/E ratios at the start of their industry cycle and low P/E
ratios at the end of their cycle, since profits are low in the beginning and high at the end. In such cases, an investor would need
to evaluate the PE ratio adjusted for the industry cycle. Besides, some other sectors such as FMCG, pharma and IT have higher
P/E ratios. Hence, in order to understand if a stock is undervalued or overvalued, comparison is the key while using the P/E
ratio for analysis.

There are a few points that one should keep in mind while considering the P/E ratio. Apart from the growth in earnings, there
are several other factors that impact the P/E ratio. These include:

a) Earnings stability: A more stable earnings profile would support a higher PE ratio.

DSIJ Pvt. Ltd. : Office no 211, Vascon Platinum Square, Next to Hyatt Regency, Vimannagar, Pune- 411014 I
Registered Office Address: 419-A, 4th Floor, Arun Chambers, Tardeo, Next to AC Market, Mumbai - 400034

SEBI Research Analyst - INH000006396​ Website : www.DSIJ.in


DEMOCRATIZING WEALTH CREATION

b) Dividends: Dividends are a sign that a company is confident of achieving growth in the long term. Higher dividend
payouts (percentage of earnings that are paid as dividends) would lead to higher PE ratios.
c) Return on Invested Capital (ROIC): A higher ROIC would indicate higher long-term growth.
d) Interest rates: As all cash earnings are discounted at relevant interest rates, lower interest rates would support higher PE
ratios.

Types of P/E
There are two types of P/E ratio – the trailing P/E ratio and the forward P/E ratio.
The trailing P/E ratio uses the earnings of the past 12 months and provides a relatively more accurate view of the stock’s per-
formance. It is estimated by dividing the current market price of a company’s share by the company’s 12-month earnings per
share.

On the other hand, when the price of the share is divided by the estimated next 12-month earnings per share (EPS), it is called
forward PE ratio. In simple terms, this ratio is calculated by using the expected earnings for the next 12 months and is based
on an estimate of the future earnings.

P/E ratio or PEG ratio


While only the P/E ratio seems to be an inadequate option, adding a company’s expected growth into the ratio helps to adjust
the result for companies that may have a high growth rate as well as a high P/E ratio. Generally, it is assumed that the lower
the PEG ratio, the more the stock may be undervalued, given its future earnings expectations, and hence, many prefer the
ratio to be below 1. The PEG ratio gives a more complete picture compared to the standard P/E ratio, since the PEG ratio is
nothing but an enhancement of the P/E ratio by adding expected earnings growth into the calculation. Hence, the PEG ratio
is considered to be an indicator of a stock’s true value and, thus, it is a better choice while analyzing equity investment oppor-
tunities.

DSIJ Pvt. Ltd. : Office no 211, Vascon Platinum Square, Next to Hyatt Regency, Vimannagar, Pune- 411014 I
Registered Office Address: 419-A, 4th Floor, Arun Chambers, Tardeo, Next to AC Market, Mumbai - 400034

SEBI Research Analyst - INH000006396​ Website : www.DSIJ.in

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