PE ratio (Price to earnings ratio), as an investor when we talk about financial ratios then pe ratio is an important ratio, in this article we will talk about what is PE ratio, PE ratio formula how to calculate it and finally we will understand it with an example.
What is PE Ratio ?
It’s a valuation ratio and most widely used ratio. You might have heard or read PE ratio everywhere. PE ratio is calculated as the price of a stock divided by its earnings per share. PE is also sometimes called ‘earning multiple’, ‘price multiple’ or simply as ‘multiple’. Some investors use financial statements to create ratios that can help compare the performance of similar companies.
PE Ratio formula :
PE = Share Price / EPS (Earnings per share)
In this article, you’ll learn how investors can use the P/E ratio to help compare the valuation of two or more companies. Let’s look at an example.
Suppose there are two companies that both make and sell toys.
Company A is trading for 60 rs per share, while Company B is trading for 10 rs per share.
A new investor might assume the 10 rs stock is the best value because it’s the cheapest. But this isn’t necessarily true.
A low share price does not mean a stock is undervalued. A stock is considered undervalued when its price is low relative to the amount of money the company earns, rather than compared to the price per share of similar companies.
To help compare these two companies and determine which may be the better value, we need a common measurement, that is pe ratio.
The P/E ratio simply compares a stock’s price to its company earnings, or profit. Now, back to our example. Let’s say Company A sells a lot of toys and earns a profit of 100,000 rs a year.
Company B earns a profit of 10,000 a year.
We know each stock’s share price and each company’s earnings, but we don’t know how many shares have claim on the earnings.
To put it another way, we need to know how many shares the company has issued to calculate the value of each share relative to the company’s overall earnings. This calculation is known as earnings per share, or EPS.
Suppose Company A has 50,000 outstanding shares and 100,000 in earnings, each share has a claim on an EPS of 2. Here EPS is (100,000 / 50,000 = 2)
Now that we have Company A’s EPS, we can calculate the P/E ratio. At a price of 60 rs per share and an EPS of 2 rs.
Here we will use PE ratio formula :
Company A’s P/E ratio is 30. (60 / 2 = 30)
This means its stock is trading at 30 times its earnings per share.
Let’s calculate Company B’s P/E ratio. Suppose Company B has 10,000 outstanding shares and 10,000 rs in earnings, resulting in an EPS of 1 rs.
The stock is at 10 per share, which means Company B is trading at 10 times its earnings or has a P/E ratio of 10. (10 / 1 = 10).
In this example, Company B may be a better value, not because it has a lower stock price, but because it has a lower P/E ratio.
In other words, the lower the P/E, the less an investor is paying per dollar of a company’s earnings. Although the P/E ratio is the most common valuation measurement, it isn’t the only indicator that should be used when evaluating a stock.
For instance, some stocks may have low P/E ratios because they have limited growth potential. If Company B sells regularly drop and don’t have the potential to grow in future then definitely it will trade at low pe ratio.
However, if both companies are expected to grow at similar rates, then Company B could be the better value based on its P/E ratio. Also keep in mind that a high P/E ratio isn’t always bad.
For example, suppose Company A is doing well because it invented a new type of toys that pushes itself. This new product could increase demand for it, and the company could grow very quickly and potentially increase earnings. This kind of growth could justify a high P/E ratio.
In this case, a high P/E ratio could indicate greater expected growth opportunities. If you expect earnings to grow, the current price may be worth the investment. The P/E ratio is a commonly used and versatile fundamental analysis tool because it can help investors identify value and growth stocks.
Just remember to compare price and earnings, and to keep earnings potential and other factors in mind when evaluating stocks. Because the P/E ratio only factors in earnings per share and price, investors should consider using other metrics like dividends or projected future earnings to help determine a stock investment’s potential.
That’s the end of this article. If you get any information from it then don’t forget to share it.