What Is Price-Earnings Ratio?
Price-earnings ratio also known as P/E ratio is a measurement tool for valuing a company with its stock price relative to its per share earnings. Simply the price-earnings ratio is the earnings multiple of a share.
In the other scene if, the company grow with flat earnings, the P/E can be considered as the number of years the company will take for the pay back the amount, each share costs.
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P/E Ratio Formula and Calculation
Price-earnings ratio can be calculated by dividing the current stock price of the company by the earnings per share (EPS) of the company.
P/E ratio = Market Price Per Share / Earnings Per Share (EPS)
To calculate the price-earnings ratio you need current stock price that can be found through the stock exchange, where the stock is listed. You can get the earnings per share (EPS) from the income statement.
Suppose a company’s current stock price is quoting at $100 and the basic earnings per share of the company is $10. So P/E ratio of that particular company = $100/$10 = 10.
What Does The P/E Ratio Tells About A Stock?
The price-earnings ration varies across different industries, for example P/E ratio for IT industry is higher than the commodity industry, because of future demand and growth.
The P/E ratio generally gives the idea about the stock, whether it is overvalued or undervalued or trading with good valuation by observing its past industry P/E.
A stock with higher P/E is considered as a growth stock or the investors are expecting growth with in the company in coming years. But, in some cases with decrease in earnings of a stock with good asset quality and fundamental quality leads a higher P/E. However, investing in these type of stocks is quite risky as their behavior is unpredictable. So investment in these type of stock is not recommended, unless a its quality stock.
Lower P/E ratio of a stock is generally considered as a under-valued stock or investors are expecting a slowdown in the company’s earnings. Sometimes because of some corporate governance issue or regulatory issue stock price goes down resulting lower P/E.
Company with a good fundamental having lower P/E is considered as value investing, unless the industry is facing a slowdown. The low P/E stocks can be found in mature industries or those who pay a higher rate of dividends.
Justified P/E is quite tricky to calculate. Here is the formula for the justified P/E. Justified P/E = Dividend Payout Ratio / R – G Where, R = Required Rate of Return G= Sustainable Growth Rate
Types of P/E Ratio
There are two types of price earnings ratio on the basis of its calculation. Those are;
Forward Price-Earnings Ratio
The forward P/E ratio can be interpreted as the company’s future earning projection instead of its actual earnings. The forward P/E ratio can be calculated by dividing a stock’s current share price by projected future earning per share (EPS). The forward P/E ratio is quite unpopular and sometimes referred as projected price-earning ratio.
Trailing Price-Earnings Ratio
The trailing P/E ratio can interpreted as the company’s actual earnings instead of company’s projected earnings. This method is considered as one of the most accurate ways to determining the company’s valuable (stock price). The trailing P/E ratio can be calculated as current market price of the share divided by the EPS from previous year.
Importance of Price-Earnings Ratio (P/E Ratio)
- P/E ratio is an fundamental analysis tool that helps investor to determine, whether the stock is overvalued or under valued or justify its price.
- It helps investor to find out whether the company is growing or not.
- P/E ratio combined with other fundamental analysis tools can be quite effective.
In summery, P/E ratio can really helpful to find out the stock’s growth and performance over years. The trailing P/E can be the most popular method to calculate price-earnings ratio, but the forward P/E helps investor to successfully judge the company’s future performance.
But, all this just for speculation and nothing lasts in market’s volatility in shorter terms.