PE Ration

This query is : Resolved

Querist : Anonymous

Querist : Anonymous (Querist)

09 August 2010 Dear Friends, can anyone explain me what is PE ratio & how it is useful for determine the future of any company, explain with example. Thanks in advance.

CMA. CS. Sanjay Gupta

CMA. CS. Sanjay Gupta (Expert)
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11 August 2010 Price-To-Earnings Ratio is one of the simplest and most popular method of valuation which measures the price paid for a single share in comparison to its earnings per share. It is calculated by using the following formula:

PE Ratio= Market Value Per Share / Earnings Per Share (EPS)

P/E ratio can be either on trailing or forward basis. Trailing P/E is a historical approach in which the earnings of past 12 months are considered. Forward P/E is a futuristic approach in which projected earnings for next 12 months are taken into account for valuation. If some major shift is revenue pattern is expected in future, then it is recommended to use Forward P/E instead of Trailing P/E. Given the fact that stock prices of listed companies are usually volatile, their P/E will also be changing very frequently.

Comparison of P/E ratios with other companies in the same sector, or to the capital markets in general, or against the company’s own historical P/E ratios is done to identify better alternatives. A higher P/E ratio usually means that investors are willing to pay more for each unit of net income, so the stock is more expensive in comparison to one with lower P/E ratio. However, it must be understood that evenif a company has a low P/E ratio, it doesn’t necessarily mean that it is undervalued. In fact it may also mean that the company’s earning could be subject to flat / negative growth due to financial trouble.

In general, the P/E ratio is higher for a company with a soaring growth rate. Thus, using just the P/E ratio as a valuation tool can make high-growth companies overvalued than their peers. If the P/E ratio is divided by the earnings growth rate, the resulting ratio called as Price/Earning to Growth Ration (PEG) can be a better alternative for comparing companies with different growth rates. Lower PEG is better option and vice-versa.

Though P/E is a very handy method of valuation, one need to understand that it does not cover the outstanding liabilities of the organization and hence, the investors need to carefully review the balance sheet before making any investment commitments.