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What is P/E (Price to Earnings) Ratio and how it is used in the Stock Market?

Introduction

Price to Earnings Ratio

Before we understand what is Price to Earnings (P/E) ratio. Lets first understand what is Price and Earnings of a company.


  • The price refers to the market price per share of a company. The market price or price is will be the current value at which the company’s stock will be trading. This price fluctuates throughout the trading day as shares are bought and sold on our exchanges in the stock market. The change in price is determined by supply and demand of the stock, where higher demand for a particular stock increases its price and vice versa.

  • The earnings refer to a company's profit. More specifically, Earnings per Share (EPS) is calculated by taking the net income of the company, subtracting any dividends for preferred stock, and dividing by the number of outstanding shares. It is essentially the portion of a company's profit allocated to each share of stock. You can find this number from the Company’s Annual Report.


Using the above, we then calculate a ratio which is called P/E ratio. The formula goes like this:

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


How do we get EPS (Earnings Per Share)?


Since EPS is shared via the company’s Annual Report and Quarterly report, it becomes difficult to calculate EPS at the given point of time. So for this we take trailing EPS or forward EPS. Trailing 12 months (TTM) represents the company's performance over the past 12 months. Another is forward EPS, which is is the company's advice on what it expects in future earnings.

Interpretation of a P/E for a stock.


Now that we got EPS, you will be confused on where P/E ratio is used in the stock market. A P/E ratio is used to check the valuation of the current stock price. Using this ratio we can check if the current price of the stock is overvalued or undervalued.


A high P/E ratio could indicate that a company's stock is overvalued, or it could mean that investors are expecting high growth rates in the future. Conversely, a low P/E ratio might suggest that a company's potential future earnings are being undervalued by the market.


However, a low P/E ratio doesn't automatically mean a stock is a good buy; investors must consider other factors and metrics for a comprehensive analysis.


How to use P/E (Price to Earnings) ratio?


The best way to understand the significance of P/E is to use it with its sector P/E. Every sector in our stock market, for example, IT Sector P/E might be at 25 while TCS share price will be at 15. With this interpretation, we can say, TCS is undervalued compared to its sector.

Limitations of Using the P/E Ratio


Companies that aren't profitable and have no earnings—or negative earnings per share—pose a challenge for calculating P/E. Views among analysts vary about how to deal with this. Some say there is a negative P/E, others assign a P/E of 0, while most just say the P/E doesn't exist (N/A) until a company becomes profitable.


A main limitation of using P/E ratios is for comparing the P/E ratios of companies from varied sectors. Companies' valuation and growth rates often vary wildly between industries because of how and when the firms earn their money.


As such, one should only use P/E as a comparative tool when considering companies in the same sector because this is the only kind that will provide worthwhile results. For example, comparing the P/E ratios of a retail company and the P/E of an oil and gas drilling company could suggest one is the superior investment, but that's not a cogent conclusion. An individual company’s high P/E ratio, for example, would be less cause for concern when the entire sector has high P/E ratios.


Conclusion


Keep in mind, the P/E ratio is merely one of many instruments. Although it can yield important understandings about a company's value, it needs to be used alongside other data and metrics to make well-informed investment choices.

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