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Price - Earnings Ratio (P/E)

How much do you pay for one rupee of a company's earnings?

This is what the price to earnings ratio, or P/E ratio, tells us. For example, a stock with a P/E ratio of 20 means you are paying 20 rupees for one rupee of earnings.

The P/E ratio is the most widely used measure of a stock's value. The higher the P/E ratio, the more you are paying for a rupee of earnings, and the more expensive the stock.

P/E ratios are of two types.

First, the trailing P/E, which uses the prior twelve months of earnings.

Second, the forward P/E, which uses the expected earnings for the next 12 months.

The forward PE is usually a better indicator, but is more uncertain, since future earnings have to be estimated.

So how do you use it?

Well, P/E ratios are used for two purposes.

The first is to compare similar stocks, for example, two stocks in the same industry. The stock with the lower P/E is cheaper and could be a better investment.

The second is to compare a stock or index with itself over time. If the P/E is low relative to its historical levels, that is a potential buy signal.

That said, using the P/E ratio has its pitfalls.

If you see a stock with a low P/E ratio, think about why it is low. If it is low because the outlook for the company is poor (i.e earnings are going to fall), then you should avoid that stock.

Now, the P/E ratio could also be low because prices are temporarily down.

For example, market sentiment may be bearish. If the company's earnings are solid, then you may have a bargain on your hands.

These are exactly the kind of stocks the Equitymaster research teams looks for.

The Price to Earnings Ratio Formula

The P/E ratio is the market price per share divided by the earnings per share.

The market price per share is simply the stock price. If you want the trailing P/E, the earnings per share can be found on the most recent income statement.

If you want the forward P/E, you use estimated future earnings per share.

P/E ratio = market price per share/earnings per share

Calculating the Price to Earnings Ratio: An Example

Suppose Bajaj Auto's current stock price is Rs 3,135 and their most recent earnings per share is Rs 134.

Using our formula gives us a P/E ratio of 23.4.

Bajaj Auto P/E = 3,135 / 134 = 23.4

Comparing Price to Earnings Ratio with Other Indicators

How does the P/E ratio compare to other indicators, such as Price to Book Value (P/BV) or price to sales (PS)?

When we buy shares in a company, we are buying into their future earnings. After all, earnings are what is left for shareholders once all expenses are paid.

Thus, the P/E ratio is usually the most relevant for investors. However, there may be cases where other indicators are more useful.

If a company is close to liquidation (when all assets are sold off and liabilities are paid), the P/BV ratio is a better indicator.

This is because if a company is liquidated and stops operating, shareholders are left with the book value of the firm.

One downside of the P/E ratio is that earnings can be manipulated. One-off charges, depreciation, accruals, and various accounting anomalies can impact the bottom line.

On the other hand, sales, or revenues, are more difficult to manipulate.

The Price to Sales (P/S) ratio is cleaner than the P/E ratio and can be a better indicator of the company's overall health.

This is especially important if we are trying to gauge the underlying demand for a company's product. If there is a big divergence between the P/E and P/S ratio, this could be a sign that the reported earnings are not reliable.

Sometimes the P/E ratio can be of no use at all.

If a company has made losses and earnings are negative, so is the P/E ratio. A negative P/E ratio has no useful interpretation. When this happens, you should use other indicators such as P/BV or P/S.

Price to Earnings (P/E) Ratio Analysis

The price to earnings ratio is the ratio of a company's stock price to the company's earnings per share. Find out how this ratio is calculated and how you can use it to evaluate a stock.

Recommended Reading

Here are links to some very insightful Equitymaster articles and videos on the price to earnings ratio.

Happy Investing!

FAQs on Price - Earnings Ratio

1. What is the formula used to calculate the P/E ratio?

The PE ratio is calculated by dividing the market price of a company's share by the earnings per share.

The market price is simply the stock price. The earnings per share can be found on the most recent income statement. If you want to calculate the forward P/E, you can use the estimated future earnings per share.

P/E ratio = market price per share/earnings per share

2. Why is the P/E Ratio important?

The PE ratio is important as it helps in understanding what the market is willing to pay today for a stock based on its past or future earnings.

It can be used to compare similar stocks in an industry. A stock with a low P/E is considered to be cheaper and therefore a bargain.

It can also be used to compare a stock or index with itself over time. If the P/E is low relative to its historical levels, that is a potential buy signal.

3. How to use P/E Ratio to identify multibagger stocks?

While there's no guaranteed method to spot a multibagger stock, you can use the PE ratio to select stocks trading at low valuations to ensure you have a margin of safety while investing.

Multibagger stocks also have some qualitative rules.

If you're looking for multibagger stocks, you need to look out for ingredients such as high growth rates, expanding PE ratios, capital efficiency, debt levels and the company's competitive advantage.

Equitymaster has a screener which can help you find high growth companies. You can start your search there.

And if you want to get a sense of how big returns could be, see our list of multibagger stocks here...

4. What is a good PE Ratio?

There is no good PE ratio as it is used as a comparison tool.

However, in general, many investors consider a lower P/E ratio better. Again, these ratios are often used in a comparative sense, so what is good depends on what you're comparing it with.

Equitymaster has a screener which can help you find Low PE Stocks and High PE Stocks. You can start your search there.