8. Price to Earnings Ratio (PE Ratio):
PE = Market Price per share / Earnings per share (EPS)
Price to Earnings Ratio or the PE Ratio measures the price that the market is willing to pay for the earnings of a company.
PE is referred as a multiple of per rupee of earnings. When one refers to a stock trading at PE multiple of 12x, it means the stock is trading at twelve times its earnings. The PE multiple based on historical earnings is of limited value. The prices change dynamically, while the reported earning is updated every quarter. Therefore, prices tend to move even after the historical earning per share is known, in anticipation of the future earnings.
If it is expected that earnings of a firm will grow, then the market will be willing to pay a higher multiple per rupee of earning. The focus is, therefore, on ‘prospective’ PE or how much the current price is discounting the future earnings.
Example:
When analysts say that shares of XYZ company is trading at 20 times its 2014 earnings, but is still about 15 times the 2015 earnings, given the state of its order book. What they are saying is that the growth in EPS is likely to be high, and therefore the current high PE based on historical numbers may not be the right one to look at.
How to Analyse:
It is common to look at the PE multiple of the index to gauge if the market is overvalued or undervalued. The PE multiple moves high when prices run ahead of the earnings numbers and the market is willing to pay more and more per rupee of earnings. When markets correct and uncertainty about future earnings increases, the PE multiple also drops. A value investor, who would like to pick up stocks when they are cheap, may be interested to purchase when PE is low. It’s always advisable to also compare the PE of one company with another in the same industry to check the relative value. Please note – The PE multiple of a stable, large and well known company is likely to be higher than the PE multiple the market is willing to pay for another smaller, less known, and risky company in the same sector. So its best to track PE growth using historical trends. (If the earnings are negative, PE would not be available).
