Price-to-Earnings (P/E) Ratio

Price-to-Earnings (P/E) Ratio is the ratio to determine the value of a company that measures its current share price to its EPS. PE ratio is one of the most popular valuation metric of stocks. It provides indication whether a stock at its current market price is expensive or cheap A high P/E Ratio means that the company’s stock is overvalued. The P/E ratio helps the analyst set a value against similar companies in the same sector or across a certain period.

If earnings of a company are expected to grow in the future, the share price goes up and vice versa. If the share price grows much faster than the earnings growth then PE ratio becomes high. If the share price falls much faster than earnings, the PE ratio becomes low.

A high PE ratio means that a stock is expensive and its price may fall in the future. A low PE ratio means that a stock is cheap and its price may rise in the future. The PE ratio, therefore, is very useful in making investment decisions.

There are two kinds of P/E ratio:

• Forward P/E

• Trailing P/E

If a company has no earnings or is meeting losses, the P/E will be expressed as N/A meaning that the ratio is not available or applicable.

Stocks in different sectors trade in different valuation (PE) ranges. Usually stocks with higher earnings growth potential have higher PE ratios. Therefore, we cannot use a single PE level across all stocks to infer whether the price is attractive or not. You should look at historical PEs of a stock and see if the current PE is near the higher end of the range or near the lower end of the range. If the stock is trading near the lower end of the range then it can be a good investment opportunity subject to other factor.

Also, some companies have a Negative P/E ratio. A negative P/E ratio happens when a company has negative earnings or loses money. If a company’s earning per share is lower than zero, then the stock can have a negative P/E ratio. Any company (big/small) can have a negative P/E ratio. However, if any company has a consistent negative P/E ratio then it is not generating enough money.

PE ratios could vary from industry to industry. A plausible way of determining if a sector or industry is overpriced is when the average PE ratio of all the organisations in that sector or industry has values much more than the historical P/E average.