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 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.
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 dividend must be subtracted from the annual income and then divide the amount by the weighted average number of share. 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 is 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 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 The 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.
Investors can compare companies on their price to earnings ratio to find the better stock to invest. One should compare between 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 for paying for a higher PE too. Finally PE Ratio meaning and formula is quite a vital concept. Long-term investors should follow this.