Price to Earning Ratio (P/E) –
Price to Earning ratio tells us relationship between the market price and EPS. PE is very important metrics used by analysts and investors to determine stock valuation. Price to Earning Ratio can be calculated by dividing market price by EPS. PE means how much market price is multiple of earnings.
P/E = Share Price / Earning Per Share = Price / EPS
PE helps us to determine whether the stock is undervalued or overvalued by comparing the PE with sector PE or other companies.
Lets take examples,
In example, company A and company B has same market price that is Rs 500, but different EPS that is company A has EPS of 50 and company B has EPS of 25, so from PE formula PE of company A is 10 and company B is 20.
Now if we compare that PE with sector PE that is 10, we can say that company A is undervalued or cheap and company B is overvalued or expensive.
So company A has low PE and company B has high PE, now low PE means company is undervalued or it also means investors are not willing to pay more money to that company because they don’t see high growth. High PE means company is overvalued or it means investors are willing to pay more price because they see growth in that company. In shorts PE tells us about future aspects.
PE is important metrics to use but it has some drawbacks.
- PE varies every time because it depends on market price.
- EPS can be misleading.
- Best performing stocks have always high PE.
- Worst performing stocks have low PE.