One of the most important financial ratios that investors use as part of a financial analysis exercise is the PE ratio. It offers a deep insight into the company’s financials and allows investors to gauge its performance in a better manner. Since the PE ratio formula is easy to understand, investors can quickly compute the ratio within a few minutes.
Wish to know the meaning of the PE ratio and how to calculate it for a company? Continue reading to find out all about this key financial metric.
Open Trading Account and Start Trading!
The PE ratio, also known as the Price-to-Earnings ratio, is a popular financial ratio that compares the current share price of a stock to the earnings generated by the company. The ratio provides investors with an insight into the value of the company and lets them know whether the stock is undervalued or overvalued. The PE ratio is also referred to by many investors as the earnings multiple or the price multiple.
Now that you’ve understood the meaning of the PE ratio, let’s take a look at the formula that’s used to calculate it.
PE Ratio = Current Market Price Per Share ÷ Earnings Per Share
While the PE ratio formula mentioned above is the most popularly used one, a few investors also use another modified version to compute the metric. Here’s a quick look at what it is.
PE Ratio = Current Market Capitalisation ÷ Total Net Earnings
To understand how the PE ratio is computed, let’s take up a hypothetical example.
Say that you wish to find out the PE ratio of a company HK Limited. Currently, the company’s stock is trading at Rs. 580 per share. The company’s total earnings in the previous financial year were Rs. 58 crores. The total outstanding number of shares of HK Limited is 11 lakhs.
Now, before we proceed to use the PE ratio formula, let’s first find out the earning per share (EPS).
Earnings Per Share = Total Earnings ÷ Total Outstanding Shares
Earnings Per Share = Rs. 58 crores ÷ 11 lakhs = Rs. 527
Substituting the values in the PE ratio formula that we saw above should give us an accurate picture of the metric.
PE Ratio = Rs. 580 ÷ Rs. 527 = 1.10
As you can see, the PE ratio of HK Limited comes up to 1.10. This means that the current market price of the company’s stock is 1.10 times higher than its earnings.
A company that has a PE ratio of 1 is said to be accurately valued. On the other hand, if the PE ratio is less than 1, the stock is said to be undervalued since it effectively means that the company’s earnings are more than its current market price. Investors usually look for undervalued companies since they have more chances of going up in the future.
However, if the PE ratio of a stock is more than 1, it means that the stock is overvalued since the company’s earnings are lower than its current market price. Investors generally stay away from overvalued companies since they have higher chances of going through a price correction.
That said, not all overvalued companies are bad investments. Companies with PE ratios that are marginally higher than 1, say 2 to 4, may still be good investment options. Furthermore, companies operating in some industries generally tend to be overvalued by nature. So that is something that needs to be accounted for as well.
Therefore, as an investor, you should always compare the PE ratio of a company with that of its peers and the industry average. This will give you a much better perspective of where the company stands.
With this, you must now be aware of the meaning of the PE ratio, its significance and how to compute it for a company. Now, relying on the ratio alone to make investment decisions is inadvisable. Investors often read the PE ratio along with the PB (Price-to-Book) ratio and use the information to arrive at an investment decision.
For instance, if both the PE ratio and the PB ratio of a company are significantly overinflated, investing in it would be inadvisable since the stock may be correct anytime. On the other hand, if both the PE ratio and PB ratio of a company is closer to its accurate valuation or undervalued, you may consider investing in it since the chances of the stock price going up in the future may be high.