Understanding Price-Earnings Ratio

Price-Earnings ratio is used in relative valuation for companies. This measures the current share price relative to the earnings per share of the company. Investors use terminologies like Price multiple or earnings multiple for this as well. The earnings per share is calculated as Net income/Total number of outstanding shares. It indicates the earnings of the company on per share basis. The PE ratio is an important relative valuation metric. It is calculated using a uniform formula Market Value per Share / Earnings per Share

It is a metric to determine how much amount an investor is willing invest in a company, to earn one dollar of that company’s earnings. Hence, P/E is also termed as the price multiple. If a company is currently trading at earnings multiple (P/E) of 10, the interpretation in simpler terms is that an investor is willing to pay $10 for $1 of current earnings.

A PE ratio may not be a good indicator for companies with negative earnings. Moreover, a PE ratio of a company in standalone may not be an excellent indicator. It must be used as a comparative analysis with other companies (peers) or with the average sector PE to arrive at a decision for valuation.

We can compare the PE of a company to ascertain if the stock is over-valued or under-valued in the market. If the PE ratio for a company is higher than its peers or the average sector PE ratio, it can mean the price in relation to the earnings of the company is higher, and hence the stock is over-valued. Similarly, a low PE in comparison to its peers may mean the company is trading cheap in the market compared to its peers.

However, this is not the only way to judge the PE ratio. It should be taken into consideration with other factors of the company as well in total, to arrive at any valuation decision. Even a high PE ratio necessarily may always not mean an overvalued stock; it may also just mean that the demand for the stock in the market is high since the expectation of the investors are high, and vice-versa. Hence it is always advisable to consider the overall factors while performing valuation.

Leading and trailing PE ratios are also used by investors and analysts to arrive at valuation for a company. The forward or leading PE as the conventional term is calculated merely in relation to its predicted or forecasted earnings, unlike the standard PE ratio is calculated using its current earnings. The rationale behind using forecasted earnings is just to understand the accurate picture of earnings of the company going forward and to arrive at the PE ratio considering the future earnings which seems to be more accurate technically. However, the current market price of the stock is used. On the other hand, a trailing PE ratio uses the earnings of the previous 12 months.


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