What is the PE Ratio? Find out the Meaning, Formula, Types and More

Fundamental analysis involves determining the true or intrinsic value of a company’s shares, so you can assess if the company is overvalued, undervalued or accurately valued. To perform this analysis, there are many ratios and financial metrics that you can rely on. One of the most commonly used ratios is the price-to-earnings ratio — or the PE ratio as it is more commonly known.

If you are interested in mastering the art of fundamental analysis, it is essential to understand what the PE ratio is in the share market and also to have a clear idea of what a good PE ratio is. This will help you assess the valuation of the stocks you are interested in and make accurate judgements about whether or not to invest in them.

What is the PE Ratio? 

The price-to-earnings ratio is the ratio of the current market price of a company’s shares to the earnings per share (EPS). It can be calculated for different periods. However, most analysts and investors use the 12-month PE ratio to compare stocks and make investment decisions.

One of the most popular and widely used financial valuation tools for stocks across the world, the PE ratio is a financial metric that quantifies the relationship between the market price of a company’s shares and its earnings per share. The EPS is simply the net profit of the company divided by the total number of outstanding shares. It shows you how much of the earnings of the company can be attributed to each of its shares.

By calculating the PE ratio for a stock, you can get a better idea of its current market price relative to its EPS.

PE Ratio: Formula, Computation and Interpretation

The formula for the price-to-earnings ratio is hidden in the name itself. It is calculated by dividing the market price of a company’s shares by the earnings per share. Check out the formula below.

Price-to-earnings ratio (PE ratio) = Market value per share ÷ Earnings per share

Since the market value and the EPS are both expressed in terms of rupees (or any other currency, as the case may be), the PE ratio has no units and is an absolute value. Let us now take a closer look at an example to understand how you can calculate the PE ratio of any company’s stocks easily.

Say a company’s shares are currently trading at Rs. 500 per share, and its earnings per share is Rs. 40. In that case, the PE ratio will be computed as shown below.

PE ratio: 

= Market value per share ÷ Earnings per share= Rs. 500 ÷ Rs. 40= 12.5

This means that for every Re. 1 of the company’s earnings, you will have to pay Rs. 12.50. This is the most fundamental way to interpret the PE ratio.

What is a Good PE Ratio?

Now that you know what the PE ratio is in the share market and how you can calculate this financial metric, you may be wondering what a good PE ratio is. If that’s the foremost query in your mind, you’re not alone. Investors typically find themselves in this dilemma more often than not. However, there is no specific range of PE ratios that can be classified as good or bad.

In general, a higher PE ratio may mean one of two things: 

Investors may be expecting an increase in the company’s earnings, and may therefore be willing to pay a higher price for its stocks, or

The company’s shares may be overpriced in comparison to its earnings, meaning that it is overvalued.

Similarly, a lower PE ratio may mean one of two things: 

Investors may be expecting a dip in the company’s earnings in the future, and may therefore be reducing the price they are willing to pay for its stocks, or

The company’s shares may be priced much less than what its earnings warrant, meaning that it is undervalued.

To understand which of the above scenarios may be true, you could compare a company’s current PE ratio with its historical PE ratio. If the ratio has recently seen an increase or a dip, it could be in response to changing investor sentiment. However, if the PE ratio has historically been higher (or lower) than the industry average, it could be indicative of overvaluation (or undervaluation).

Types of PE Ratio

So, you’re now aware of what the PE ratio is and how you can identify what a good PE ratio is. However, it’s also important to be aware of the different types of PE ratios. Check out these details below.

Trailing Twelve Months (TTM) PE Ratio:

The trailing twelve months PE ratio is a retrospective financial metric, which is calculated by dividing the current market price of the share by the company’s EPS over the previous 12 months (or past 4 quarters).

This is a highly objective ratio because it does not rely on any estimates, but instead uses accurate reported figures. On the flip side, its key limitation is that past earnings do not guarantee future earnings.

Forward PE Ratio:

As the name indicates, a forward PE ratio is a prospective financial metric. It is calculated by dividing the current market price of the share by the company’s estimated or projected EPS over the next 4 quarters. For this reason, it is also known as an estimated PE ratio.

As you may have guessed, the key limitation of this ratio is that it relies on estimates that could turn out to be inaccurate. If the projections are overly optimistic, it may lead to a lower PE ratio (and vice versa).

Absolute PE Ratio:

The absolute PE ratio is computed for the current time period. It could be the TTM ratio or the forward PE ratio. However, as long as the current market price is used to compute the metric, it is considered as an absolute PE ratio.

This can be limiting because the PE ratios of stocks in different industries may be different. So, comparing the absolute PE ratios of two stocks from different industries may not give you an accurate picture of how they match up against each other.

Relative PE Ratio:

The relative PE ratio facilitates a comparison between the current absolute PE ratio and a range of past PE ratios. The absolute PE ratio is compared with the highest PE ratio in the range chosen.

Let’s look at two examples to understand this: Say the current absolute PE ratio of a stock is 10 and the highest PE ratio of the stock in the past 10 years was 12. In that case, the relative PE ratio will be 0.833333. 

Now, if the current absolute PE ratio of a stock is 15 and the highest PE ratio of the stock in the past 10 years was 12. In that case, the relative PE ratio will be 1.25.

So, a lower current absolute PE ratio will lead to a relative PE ratio below 1, indicating a fall in the share price relative to its earnings. However, a higher current absolute PE ratio will lead to a relative PE ratio above 1, indicating a rise in the share price relative to its earnings.

Conclusion

If you are planning to buy and hold a stock, it is essential to perform a fundamental analysis and ensure that the company you are planning to invest in is correctly valued or undervalued. This way, when the market corrects itself, you can expect a capital appreciation. Overvalued stocks do not make for good investments because of the potential capital depreciation that could occur. And now that you know what the PE ratio is in stocks, you can use it in your stock valuation exercise and make informed investment decisions.