If you’re starting your journey into stock market investing, you’ve probably come across the term “P/E Ratio.” It’s a crucial metric used by investors to understand how expensive or undervalued a stock is compared to its earnings. But what exactly does a P/E ratio mean? How do you calculate it? What types of P/E ratios are there? And how can this number help you make smarter investment decisions?

In this guide, we will answer all these questions for you. Let’s start!

What is the P/E Ratio?

P/E stands for Price-to-Earnings Ratio. It’s a number that tells you how much investors are willing to pay today for one rupee of a company’s earnings. In other words, it compares the current market price of a stock to the profit the company generates for each share.

If a stock has a P/E ratio of 20, it means investors are paying ₹20 for every ₹1 the company earns. This ratio helps you determine whether a stock is overvalued or undervalued relative to its earnings and compared to other companies in the same industry.

How to Calculate the P/E Ratio

Here is the formula to calculate the P/E ratio:

P/E Ratio = Current Market Price Per Share/Earnings Per Share (EPS)

  • Current Market Price Per Share: This is the latest price at which the stock is trading on the stock exchange.
  • Earnings Per Share (EPS): This is the profit a company makes divided by the number of outstanding shares. EPS shows how much money the company earns for each share.

Suppose a company’s stock price is ₹500, and its EPS is ₹25.

P/E Ratio = ₹500/₹25 = 20

A P/E ratio of 20 means that investors will pay ₹20 for every ₹1 in earnings that the company generates.

Absolute P/E Ratio and Relative P/E Ratio

In this section, let’s understand the difference between absolute and relative P/E:

Absolute P/E Ratio

This is the traditional P/E ratio. It involves dividing the current stock price by earnings, either past earnings (trailing EPS) or expected future earnings (forward EPS). This number indicates how much investors are willing to pay today for each rupee the company earns currently or is expected to earn in the near future. 

Relative P/E Ratio

Relative P/E puts that absolute figure into perspective by comparing it against a benchmark. This benchmark could be:

  • The company’s own historical P/E ratios over a period (like the past 5 or 10 years)
  • The average P/E ratio of the company’s industry or sector
  • A market benchmark, such as the Nifty 50’s average P/E

By expressing the current P/E as a percentage of the benchmark P/E, investors can understand whether the stock is currently valued higher or lower than usual.

For instance, if the current absolute P/E is 18 and the benchmark P/E is 20, the relative P/E is 90% (18/20). This means the stock is trading below its benchmark valuation, which may suggest undervaluation. Conversely, a relative P/E over 100% means the stock’s valuation has outperformed the benchmark during that period.

Why Relative P/E Matters

While the absolute P/E ratio tells you the price-to-earnings relationship at face value, the relative P/E ratio adds historical or sector context, enabling smarter investment decisions. 

Types of Absolute P/E Ratios

There are two main types of absolute P/E ratios used by investors:

1. Trailing P/E (Historical P/E)

The Trailing or Historical P/E uses the company’s past 12 months’ earnings to calculate the EPS. It reflects how the company has performed recently and is based on actual reported profits.

Example: If a stock price is ₹2,000 and EPS for the last year is ₹59.60, its trailing P/E would be:

₹2000/₹59.60 ≈ 33.6

The trailing P/E is considered more reliable because it is based on actual earnings data.

2. Forward P/E (Projected P/E)

The forward P/E ratio uses expected future earnings for the next 12 months, based on analyst estimates or the company’s guidance.

Forward P/E tells you how the market values the company based on what it expects the company will earn in the future.

If the expected EPS for the next year for the same company is ₹80 and the stock price stays ₹2,000, the forward P/E would be:

₹2000/₹80 = 25

Forward P/E helps investors gauge growth potential but depends on accurate forecasts.

What Does a High or Low P/E Ratio Mean?

  • A high P/E Ratio generally indicates that investors expect high future growth and are willing to pay more for a company’s current earnings. It reflects rapid growth expectations.
  • A low P/E Ratio may indicate that the stock is undervalued or that the company is facing challenges. 

However, a high or low P/E alone doesn’t tell you if a stock is a good buy. It’s important to compare the P/E of a company with:

  • Its industry peers
  • Its own historical P/E
  • The overall market P/E

Benefits of Using the P/E Ratio

  1. Easy Valuation Metric: P/E simplifies complex company earnings into a single number, helping investors quickly compare company valuations.
  2. Helps Identify Growth vs. Value Stocks: Growth stocks usually have higher P/E ratios due to their expected future earnings, whereas value stocks may have lower P/E ratios, indicating potential bargain opportunities.
  3. Assists in Industry Comparisons: Comparing P/E ratios within the same sector can highlight which companies are overvalued or undervalued.
  4. Useful for Mutual Fund Analysis: The P/E ratio of a mutual fund is often the weighted average P/E of the stocks it holds, enabling investors to gauge whether a fund is expensive or cheap overall.
  5. Supports Investment Decision Making: Along with other metrics, such as debt levels and cash flow, the P/E ratio helps investors make informed investment choices.

Limitations of the P/E Ratio

The following are the limitations of the P/E ratio:

  • It doesn’t reflect company debt, cash flow, or sector risks.
  • Companies with no or negative earnings don’t have a meaningful P/E ratio.
  • P/E ratios vary significantly across industries, making cross-sector comparisons potentially misleading.
  • Forward P/E depends on earnings projections, which may not always be accurate.

Hence, it is wise to use the P/E ratio alongside other indicators, such as price-to-book ratio, return on equity, and revenue growth, to understand the full picture.

Conclusion

The P/E ratio is a powerful and easy-to-understand tool that investors can use to understand a stock’s valuation. Whether you are eyeing large-cap stocks or startups in growing sectors, knowing the P/E ratio will help you decide if a stock price is justified by its earnings.

Remember, no single number tells the whole story. Look at the P/E ratio with other financial data and assess the company’s industry and growth potential before making an investment decision. 

FAQs

1. What is a good P/E ratio for Indian stocks?

There’s no fixed “good” P/E ratio. Generally, a P/E between 15 and 25 is considered reasonable, but it depends on the sector and growth prospects.

2. Can P/E ratio tell if a stock will go up?

Not alone. P/E shows valuation but doesn’t predict stock price movement. Combine it with other financial indicators.

3. Is Forward P/E more important than Trailing P/E?

Both are important. Trailing P/E is based on actual earnings, while Forward P/E shows future potential. You should use them together for better insights.

4. What if a company has negative earnings and no P/E ratio?

Stocks with losses don’t have meaningful P/E ratios. Investors then look at other metrics like price-to-sales or cash flow ratios.

Disclaimer and Disclosure 

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Registration granted by SEBI, enlistment as Research Analyst with Exchange and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors. Kindly refer to  https://share.market/ for more details.Investments in WealthBaskets are subject to the Terms of Service. All investors are advised to conduct their own independent research into investment strategies before making an investment decision. PPWB acts as a distributor of mutual funds and WealthBaskets and it is not an exchange traded product. Disputes with respect to the distribution activity of Mutual Funds and WealthBaskets will not have access to Exchange investor redressal or Arbitration mechanism. The securities are quoted as an example and not as a recommendation. This is for informational purposes and should not be considered as recommendations.

PhonePe Wealth Broking Private Limited is a member of NSE & BSE with SEBI Regn. No.: INZ000302639, Depository Participant of CDSL Depository with SEBI Regn. No.: IN-DP-696-2022, Research Analyst with SEBI Regn No: INH000013387, BSE RA Enlistment Number: 5887 and Mutual Fund distributor with AMFI Registration No: ARN- 187821. Member ID: BSE- 6756, NSE- 90226. Registered office – 2, Floor 3, Wing A, Block A, Salarpuria Softzone, Service Road, Green Glen Layout, Bellandur, Bengaluru South, Bengaluru, Karnataka – 560103, INDIA. CIN: U65990KA2021PTC146954