Mumbai: The Price-to-Earnings ratio, or PE ratio, is one of the most popular valuation metrics used in the markets to analyse a stock and its valuation trajectory. ET looks at the interpretation and accuracy of PE ratio and how investors can use PE ratio to assess a stock or company.
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What is PE Ratio?
PE ratio is a commonly used valuation metric by investors all over the world. It is an indicator of whether the stock market or an index or a stock is expensive or cheap.
How is PE ratio measured?
The ratio is calculated by dividing the price of a stock or an index by the earnings per share , or EPS, (net profit divided by the number of common shares outstanding). For example, if a stock is trading at ₹50 and its earnings per share is ₹10, then the PE ratio is 50/10=5. There are two types of PE ratios: Forward PE and Trailing PE. Forward PE ratio is a forward-looking ratio that measures the current stock price with the estimated future earnings. Trailing PE is the current share price divided by the last four quarterly EPS.
Is forward or trailing PE ratio more important?
A forward PE ratio is more widely used by knowledgeable investors than trailing PE. This is because stock prices tend to discount reported earnings, while the market is forward looking. That said, many investors take forward earnings into account mostly for larger companies widely covered by analysts. For small companies, forward earnings might end up being less credible, making trailing earnings a better measure to calculate PE ratio. “Trailing PE is a starting point since it is based on historical earnings,” says Shibani Kurian, head of equity research, Kotak Mutual Fund. “Typically, markets tend to look at the forward PE ratio as it is future oriented.” Kurian says a two-year Forward PE ratio is commonly used while assessing a stock or a company.
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How to interpret PE ratio?
The PE ratio of a market, index or a stock must be compared to its historical averages or their peers. For instance, India’s PE ratio could be compared with its emerging market peers. Similarly, Infosys’ PE is compared with TCS. “Another way is to compare the current PE ratio to historical PE averages to ascertain whether it is trading at a premium or a discount,” says Kurian. A few things to be kept in mind here is PE ratio must be used to compare two companies in the same sector and their size should be similar.
What does a high or PE ratio mean? How should you interpret it?
In simple terms, a stock having a high PE ratio is considered one with expensive or rich valuations. Similarly, a stock with a lower PE ratio is cheap. The plain vanilla interpretation of this is the stock with lower PE has a chance of going up than the one with higher PE. But, in real world, it’s not that simple. A stock with a higher PE also means investors are willing to pay higher valuations for the stock because of its stronger earnings. Some stocks tend to mostly have lower PE ratios compared to peers because of their weaker earnings profile. The broader market and economic conditions also play a role there.
Do investors buy or sell stocks based on PE ratio?
PE ratio must be looked at in conjunction with other factors such as sales, cash flow, margins and operating profits, among others. PE ratio, by itself, could be misleading at times. “PE Ratio cannot be seen in isolation, it must be looked at with context to the sector and the peer group of the stock, as well as return ratios and earnings growth,” said Kurian. “But simply a high/low PE cannot be interpreted.”
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How accurate is the PE Ratio?
PE ratio by itself does not give a buy or sell signal but it certainly gives investors an idea whether the stock, index or the market is expensive or cheap. For instance, the Indian market is considered rich compared to its historical averages. The 12-month trailing P/E for the Nifty is at approximately 21.6 times, a 6% premium to its 15-year average of 20.3 times. This is deterring many long-term foreign investors from bringing in fresh money into India.
