Contrary to popular opinion, investing in the stock market is not about just simply purchasing shares of companies and hoping that it will rise one day. It involves a lot of research into the company’s financials and other aspects. A stock purchase backed by proper financial research will ensure that you purchase only the shares of those companies that are financially stable and have good future growth prospects. This is precisely why many investors resort to fundamental analysis.
Fundamental analysis is basically analysing the fundamental aspects of a business, which is its financials. A company’s financial metrics can give you a whole lot of insight, which can help you determine whether you should invest in it or not. One such metric is the Price to Earnings (P/E) ratio. In this article, we’re going to take a look at what this ratio is and how important it is for stock market trading and investment.
The Price to Earnings ratio is basically a financial metric that compares a company’s Earnings Per Share (EPS) with its current market price. Investors use the P/E ratio to determine whether a company is overvalued or undervalued.
A company is said to be overvalued when its current share price is far higher than its EPS. And on the contrary, a company is said to be undervalued when its current share price is lower than its EPS.
Many stock market investors also compare the P/E ratio of a company to that of its peers in the industry to get an idea of where it stands currently.
Calculating the P/E ratio of a company is super easy. The formula that’s used for the same is as follows -
P/E ratio = Current Share Price ÷ Earnings Per Share
Here’s a quick example to help you get a better idea of how the calculation works. Let’s take up Reliance Industries Limited. The company’s EPS is currently Rs. 23.95 and its market price per share is at Rs. 2,700. So, applying the formula mentioned above, we can easily get the P/E ratio of the company.
P/E ratio of Reliance Industries = Rs. 2,700 ÷ Rs. 23.95 = Rs. 112.73
According to the P/E ratio, the company is valued at about 112 times more than its Earnings Per Share, signifying that the company is overvalued.
Although the P/E ratio gives you insight into a company’s share price, it shouldn’t always be relied upon solely. A company that’s overvalued shouldn’t always be overlooked. Similarly, a company that’s undervalued shouldn’t always be invested in.
You should also look at other financial factors and compare the P/E ratio of the company with others in the same industry. This way, you can get a more accurate picture of where the company stands.
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