PE Ratio, often called the price-earnings ratio is a quite prominent indicator for an investor. This ratio helps to evaluate a company’s financial position, the stock’s fair market value. PE Ratio gives the idea of the growth potentiality of the stock market.
Mainly it indicates what the market is willing to pay for the earning of a company. By calculating pe an investor can get a fair scenario regarding stock price and profit. PE Ratio meaning and formula are quite important in fundamental analysis to understand for profitable investment planning.
Popular FAQ about PE Ratio
PE ratio is one of the most popularly used tools for stock selection. You can calculate it by dividing the current market price of the stock by EPS or earnings per share. It reflects the sum of money you are paying for each rupee worth of the earnings of the company.
Basically, a high P/E ratio shows that investors are expecting higher growth in the future. The current average market P/E ratio is approximately 20 to 25 times earnings. Companies that are losing money do not have a high P/E ratio. They have a low PE ratio.
You can calculate it by dividing the market value price per share by the EPS. A trailing PE ratio happens when the EPS are based on the past period. Leading PE ratios to happen when the EPS calculation depends on future predicted numbers.
A stock is simply overvalued if its present price isn’t supported by its P/E ratio result or earnings projection. The P/E ratio is also referred to as earnings multiple. Suppose, a company’s stock price is 50 times earnings, the company is likely overvalued in comparison to a company that’s trading for 10 times earnings.
What is Price to Earnings Ratio?
Before we go through the discussion of PE Ratio meaning and formula, let’s take a short look at EPS. In order to understand PE Ratio in detail, its necessary to calculate EPS first. EPS stands for or earnings per share. To calculate dividends must be subtracted from the annual income and then divide the amount by the weighted average number of shares. Therefore we can get profit per share.
PE Ratio meaning and formula
Price to earnings ratio is a ratio between market price or stock price and EPS (earning per share). PE helps investors to research and analyze what should be the stock price based on the company’s current earnings. Basically, there are two prices to earnings earning ratio, Forward and Trailing PE Ratio.
Forward Price To Earnings Ratio
This ratio is based on the previous period of earning per share, the last four quarters earnings are required here.
Trailing Price To Earnings Ratio
This ratio is an estimation of the upcoming quarter’s earnings. Trailing PE calculation is based on the future number.
Average PE Ratio
The limit of the average ratio is 20-25. Low PE indicates undervalue and high ratio indicates the overvalue of shares. So one should not buy shares only by the profit-sharing ratio indication. There are other factors too. These factors should be analyzed before investing in a stock. These are as follows:
- Market Capitalization
- The growth rate of a company
- consumer market
- Market segments
Why is PE Ratio Important?
The price of a company follows the earnings over the long-term. When earnings go up, the stock price goes up and when the earnings go down, the price goes down. Most stocks are fairly priced in a PE Ratio between 15 to 20. The price to earnings ratio also indicates the growth of a company. As per Ben Graham PE of 8.5 indicates zero growth per year, PE of 18.5 indicates 5% growth per year while PE of 48.5 indicates 20% growth per year.
- The PE or price to earnings ratio relates to a company’s share price to its EPS or earnings per share.
- A high P/E ratio may reflect that a company’s stock is over-valued, or else that investors are expecting high growth rates in the future.
- Companies that have no earnings or that are losing money do not have a price to earnings ratio since there is nothing to put in the denominator.
- Two types of P/E ratios – forward and trailing P/E. It is used in practice.
Investors can compare companies on their price to earnings ratio to find the better stock to invest. One should compare two same sectors i.e infrastructure and service sector are completely different, so comparisons between these two are not possible. A company in the same industry with a lower PE is often preferred to invest. But many times growth investors even do not mind paying for a higher PE too. Finally PE Ratio meaning and formula is quite a vital concept. Long-term investors should follow this.