Before you go ahead and invest in a stock, it is very important to first conduct a thorough fundamental analysis of the company. This is especially true if you’re a value investor with a long-term view on investments. And one of the most popular metrics that value investors take into consideration when doing fundamental analysis of a stock is the PE ratio of the company. Want to know more about the PE ratio and why it is considered to be very important? Here’s some information that can help you out.
PE ratio, also known as the P/E ratio or the Price-to-Earnings ratio, is a metric that value investors use to determine the valuation of a stock. By examining this ratio, analysts can to a certain extent conclude whether the given stock is overvalued or undervalued. The PE ratio achieves this by comparing the current market value of a stock with the earnings generated by the company.
To put it in simple terms, this ratio gives you a fair idea of what investors are ready to pay to own a stock based on the earnings generated by the company in the past.
As you’ve already seen above, the PE ratio consists of two variables - the current stock price and the earnings generated by the company. So, to calculate the ratio, all that you have to do is divide the current stock price by the earnings per share (EPS) of the stock. Here’s a quick look at the formula.
PE ratio = Current Stock Price ÷ Earnings Per Share (EPS)
Now, let’s take a look at a hypothetical example to understand how the ratio is calculated.
Say that you’re interested in a company - ABC Limited. The current stock price is at Rs. 1,100 per share, whereas the EPS Rs. 42. The PE ratio of the company is as follows.
PE ratio = Rs. 1,100 ÷ Rs. 42 = Rs. 26.19
A high PE ratio typically means that the price of a stock is higher compared to the earnings generated by the company. This indicates that the stock is overvalued. On the other hand, a low PE ratio typically means that the price of a stock is lower compared to the earnings generated by the company. This is indicative of the stock being undervalued.
That said, how do you determine if a company’s PE ratio is high or low? To do this, all that you have to do is compare the said company’s PE ratio with that of its rivals or its own industry. This way, you can easily find out if the company’s ratio is high or low.
Value investors tend to search for and prefer to invest in undervalued stocks. This is due to the fact that stocks that are undervalued typically have good fundamentals and enjoy a higher chance of share price appreciation in the future.
Now that you know the answer to the question ‘what is the PE ratio?’, make sure to use it to find out the stock’s valuation before going ahead with your investment. That said, short-term volatility in a stock’s price can sometimes lead to wrong conclusions. So, that’s something that you should keep in mind when calculating the PE ratio.
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