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Price to Earnings (P/E) Ratio

Market Live brings in the Stock Market Tutorial which explains the basics of Fundamental Analysis and Investment Valuation. Whether it is about Reading Balance Sheets or about understanding the important valuation indicators like P/E ratio or EPS – Get all the fundamental analysis aspects being explained in a simple manner here.

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The Price to Earnings (P/E) Ratio is one of the most widely employed valuation statistic of a company. This important ratio is also referred to as Price Multiple or Earnings Multiple of a company. Many believe that the most important thing you need to know about a stock is its price-to-earnings (P/E) ratio. It is also widely believed that the P/E ratio can be the most convenient method of comparing one stock’s value with another’s.  In layman’s terminology the P/E ratio signifies how expensive a stock is.

Let us get to know more about this important figure that any value investor would be looking at.

What is the P/E ratio ?

The P/E ratio is the relationship between the stock prices and the earnings. It is computed simply by dividing the market price of the stock by its earnings per share or EPS.  Earnings Per Share means simply the company’s after-tax profit divided by its number of outstanding shares.

Hence one can get the company’s market price by multiplying the P/E ratio with the EPS of the same company.  More specifically the P/E ratio can signify the actual multiple that an investor is willing to pay for a Rupee of the company’s earnings.

Price – Earnings Ratio =
Stock Price
———————
Earnings Per Share

Example

For example, if the current stock price of the company A is Rs. 1000 and its EPS is known to be Rs. 100, then the

P/E ratio for company A is calculated as 1000/10, which is equal to 10.

Types of P/E ratios

All though there are many types of P/E ratios used by various researchers and valuation experts, the most frequently used among them are the following three :

  • Trailing P/E ratio

This is by far the most readily available type of P/E ratio that is available in the financial world.  This ratio is based on the EPS for the previous periods. Hence the word ‘trailing’.

Usually it is a practice to calculate the trailing P/E based on the EPS of the past four quarters or one year.  Although not common, it can also be calculated for any specific period other than these including half yearly and quarterly calculations.

  • Forward P/E ratio

The Forward P/E ratio is based on the projected EPS of the company for the future periods.  This projection is usually done by research analysts and valuation experts based on the order book and other various financial data available regarding the business and its operation environment.

Again it is a practice to calculate the forward P/E ratio for the coming four quarters or one year.

Another less common type of P/E ratio is called the Rolling P/E ratio :

  • Rolling P/E ratio

This ratio is based on both past and the future projected earnings of the company. For example many people consider earnings in the previous two quarters and the next two quarters to determine the Rolling P/E ratio.

Since inherently both the Forward and Rolling P/E ratios are based on future projected earnings of the business, they are assumed to be less accurate when compared to the Trailing P/E. which is based on the factual earnings of the company in the past.

Next : How to make use of the P/E ratio ?


 

 

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