Price-to Earnings ratio or P/E ratio, which along with showing a co-relation, also shows a business in an open market place rather than it existing in isolation, essentially forming a pattern of the market constituents reacting to a business’s actions and showing the quantum of that relationship.
Do you wish to calculate the P/E or Price Earnings Ratio of a company? Don't miss out our P/E Ratio Calculator that's free to use and embed too! But before that, also learn in detail about P/E Ratio, its formula, how it is calculated and much more.
Ratios, in the world of finance do much more than just showing the quantum of two variable’s co-relation. They enable investors and people at large to form opinions about movements of the market and by extension, the economy in general.
Let’s learn more about P/E ratio this time in simple non-pretentious terms.
Price-to-Earnings (P/E) ratio is one of the aspects of fundamental analysis of stock markets. P/E ratio takes into account two things. The first is the earnings, which are basically earnings per share for shareholders. Note that this earnings does not mean dividend or bonus shares, which are tangible forms of income that a shareholder earns.
When we say earnings per share, these are the earnings available to shareholders (usually for the past 12 months) after deduction of all the expenses, interest payments and taxes. Out of this earnings, the company gives out dividend, retains profit, and does capital investment and much more, needless to say the physical tangible income and earnings per share are different. This is nothing but basic economic value added by the company. Earnings are usually taken
The second aspect is the market price per share. See, market price of any share is usually said to reflect information available to the people about the business whose shares are in consideration. This information can be a variety of factors such as the type of business the company is in, its assets, its management efficiency, its ability to make profit, and so on. Movements in all of these things have a positive or negative impact on the price of a share, which is in turn regulated by market supply and demand for the share.
P/E ratio establishes relationship between these two variables, which can be analyzed both, just by itself as well as over a period of time. Here’s the formula
Now, let's understand this by a simple example:
Consider this hypothetical company, Mzilikazi ltd. whose profit after tax is Rs. 10,00,000. It has 1,00,000 shareholders. The market price of the share is trading around Rs. 100.
Here, first we have to find out how much each shareholder is gaining in profit i.e. earnings per share. Since the profit is Rs. 10 lakh and there are 1 lakh shareholders, it is easy to say that each shareholder is earning Rs. 10 ( 1000000 / 100000).
= Rs 100 per share / Rs 10 EPS
Analysing this, what this basically means is that for every 10 rupees invested in the company, the company adds an economic value of Rs. 1 on that, or the earning per share would be 10% (1/10 = 0.1 * 100) of the value invested.
As a general rule of thumb, the lower the P/E ratio, the better. This is because P/E ratio is nothing but the amount to be invested in a company to get 1 rupee a return, meaning a firm with P/E ratio 4 has a greater return on investment or economic value added, than a firm with P/E ratio 10, because in one case you only have to invest 4 rupees to get 1 rupee return. But this is sort of an absolute way of looking at it.
The correct answer, like all ratios, would be that there is no good P/E ratio. But for the sake of analyzing and comparing, one should always limit the variables to be as little as possible. In this case, one company’s P/E might give some idea as to how the company is performing, however, comparing the P/E with other companies in the same industry at the same scale, like McDonalds and Burger King, or say the industry average, might give a much better idea of how the company is performing both individually and among its peers.
The third form would be to look at the ratio from a time series perspective, i.e. comparing a company’s P/E ratio with its past P/E ratios and using estimated earnings of the next quarter to form a sort of estimate for future P/E ratios. Obviously, if its reducing over a period of time, it is said that the company is performing good and vice-versa.
The first limitation would be if you looked at P/E ratio as an absolute metric for evaluation. One key thought process, or rule behind fundamental analysis is the fact that there are no absolute metrics, only relevant metrics. This means that a company might have a good P/E ratio, and you might buy the stock considering only that, but not taking into account a factor like, say past data of illegal practices of management. It may happen that a news of scandal might drive the price and P/E ratio down after that.
The second is kind of more technical one. See, like all people are different, all companies are different too. Even in similar industries, companies may have different timelines of cash flows, which means a current high P/E ratio doesn’t mean it is always going to be high and vice versa.
As mentioned above, P/E ratio is not an absolute measurement of value. As all good investors know, there is no such thing, just information, its relevance and co-relation to price. Having said that, P/E ratio does provide a good insight on a company’s performance, both by itself and among its peers.