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Demystifying Price to Earnings (P/E) Ratio

Posted in Finance Articles, Total Reads: 5028 , Published on April 04, 2011

Price to earnings ratio is one of the oldest and most frequently used metrics to evaluate stocks. The following article describes how it should be used in security analysis and how it should not be used. P/E  ratio is very simple to calculate but can be quite tricky to evaluate. It can be extremely informative at times while in some situations it can be meaningless.

It is a ratio of a company's share price to its per-share earnings (EPS). In order to calculate the P/E, simply take the current stock price of a company and divide by its earnings per share. 

P/E ratio = Market Price of Share/Earning Per Share (EPS)

P/E Ratio

P/E is calculated using earning from last four quarters. It is generally called trailing P/E. Sometimes, analyst try to estimate P/E over next one year using estimated EPS over the next four quarters. This is known as leading or projected P/E. Companies that are not profitable have generally negative P/E.

Theoretically, a stock's P/E tells us how much investors are willing to pay per rupee of earnings. For this reason it's also called the "multiple" of a stock. In other words, a P/E ratio of 20 suggests that investors in the stock are willing to pay Rs 20 for every Re 1 of earnings that the company generates. It is not just a number which tells you about the company as it do not take into account the company’s growth prospects.

P/E ratio is based upon the past earnings of the company and how it will perform in the future. Future growth is already accounted for in the stock price. As a result, a better way of interpreting the P/E ratio is as a reflection of the market's optimism concerning a company's growth prospects. If a company has a P/E higher than the market or industry average, this means that the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop.

For example, when Infosys was growing at tremendous pace its P/E ratio was over 100. But it cannot grow at this pace forever, its revenue and profits cannot maintain the same growth as before. As a result its PE dropped to 40 in 2006 and to 26 in 2011. 

In fact, PE ratio is a better indicator whether a stock is cheap or expensive. A Rs 10 stock with a P/E of 75 is much more "expensive" than a Rs 100 stock with a P/E of 20. But you cannot compare two companies from different industries. P/E ratio will only make sense, if companies within the same sector are compared. 

Therefore, two main factors which should be considered while determining whether, P/E is low or high are:

• Company growth rates: How fast has the company been growing in the past, and are these rates expected to increase, or at least continue, in the future? 

• Industry: It is only useful to compare companies if they are in the same industry. For example, FMCG typically have low multiples because they are low growth, stable industries. In contrast, the technology industry is characterized by phenomenal growth rates and constant change. Comparing a tech company to a FMCG is useless. You should only compare high-growth companies to others in the same industry, or to the industry average.

What are the problems with P/E ratio?

• Accounting: Earnings also include non cash items. So EPS for different companies from the same industry can give different picture depending upon the non cash items included on their books.

• In times of high inflation, inventory and depreciation costs tend to be understated because the replacement costs of goods and equipment rise with the general level of prices. Thus, P/E ratios tend to be lower during times of high inflation because the market sees earnings as artificially distorted upwards. As with all ratios, it's more valuable to look at the P/E over time in order to determine the trend. Inflation makes this difficult, as past information is less useful today.

A low P/E ratio does not necessarily mean that a company is undervalued. Rather, it could mean that the market believes the company is headed for trouble in the near future. In conclusion, while buying share of any company, don’t just look at the P/E ratio but it can be one of the useful parameters worth considering.

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