The P/E ratio (Price-to-Earnings ratio) is a financial metric that tells us whether a stock is overvalued or undervalued in a specific industry. It is calculated by dividing the current price of a share by the earnings per share (EPS). This ratio helps investors understand how much they are paying for each unit of a company’s earnings, and it can be used to compare the valuation of different companies within the same industry.
Table of Contents
What exactly is P/E Ratio?
The P/E ratio, or Price-to-Earnings ratio, is a tool used to evaluate how much investors are willing to pay for a company’s earnings.
It shows the collective sentiment of the market. The P/E ratio reflects the market’s perception of a company’s future prospects. A high P/E ratio indicates that investors expect higher earnings growth in the future, while a low P/E ratio might suggest that the market has lower expectations.
How is P/E ratio calculated?
The P/E ratio, or Price-to-Earnings ratio, is calculated by dividing the price of a share by its earnings.
P/E Ratio = Price of a share / Earnings Per Share (EPS)
These earnings are represented by the earnings per share (EPS), which is derived by dividing the company’s total profit (Profit After Tax) by the number of outstanding shares.
- EPS indicates the earnings generated by one share in a year.
Example of P/E Ratio Calculation
Imagine a company’s share is priced at Rs. 100, and its EPS is Rs. 5.
In this case, its P/E ratio would be calculated as 100/5 = 20.
This means investors are willing to pay Rs. 20 for every Rs. 1 of earnings the company makes. In other words, they are paying 20 times the company’s earnings per share.
Breakeven Point
The P/E ratio also tells you about the breakeven point.
The breakeven point tells you how long it will take to recover your investment through the company’s earnings. If the share price is Rs. 100 (which you have paid hypothetically) and the EPS is Rs. 5 (which you are going to get every year), it would take 20 years to earn back your investment through the company’s earnings alone:
Breakeven point = Price of the share / EPS = 100/5 = 20
Earnings from the 21st year onwards will be considered your profits.
6 Key Points About P/E Ratio
- Stocks with predictable earnings over a long period tend to have high P/E ratios.
- Growing companies generally have higher P/E ratios due to strong growth prospects.
- Stocks in the Nifty 50 index usually have higher P/E ratios compared to stocks outside the index.
- Companies with higher ROE typically have higher P/E ratios.
- Stocks with higher liquidity often have higher P/E ratios.
- Stocks with lower dividend yields may have higher P/E ratios.
What is a good PE ratio?
There’s no fixed “good” P/E ratio as it varies by industry and market conditions. Generally, comparing a company’s P/E ratio to its industry average gives a better idea of whether it’s overvalued or undervalued.
Many investors think that if a stock has a high P/E ratio, it’s overpriced, and if it has a low P/E ratio, it’s a bargain. But that’s not always true. In the Indian stock market, the P/E ratio can vary based on how attractive the business is.
- For example, companies like Nestle India and HDFC Bank often have high P/E ratios because they are market leaders, have steady business models, high returns on capital and equity, pay dividends, and have good corporate governance.
- On the other hand, businesses that are cyclical, have low returns on capital and equity, don’t pay dividends, and have poor corporate governance usually have low P/E ratios.
The P/E ratio also depends on how well an investor can value a business. Sometimes a P/E of 50 might be a good deal for one business, while a P/E of 5 might be too high for another. So, don’t rely solely on the P/E ratio to value a business.
ALSO READ
What does a high PE ratio mean?
A high P/E ratio means investors are willing to pay more for each unit of earnings, often because they expect future growth. However, it could also indicate that a stock is overvalued.
What is a low P/E ratio?
A low P/E ratio might suggest that a stock is undervalued or that the company is experiencing difficulties. It could also mean that the market has lower expectations for future growth.
Is negative P/E good?
A negative P/E ratio occurs when a company has negative earnings (losses). This is generally a bad sign and suggests that the company is not currently profitable.
What if P/E ratio is 0?
A P/E ratio of 0 means the company has no earnings. This is also typically a negative indicator.
The Bottom Line
The P/E ratio is a useful way for investors to see what the market thinks about a company. It helps in comparing different companies in the same industry and making smart investment choices. However, you shouldn’t rely on the P/E ratio alone. Other financial ratios and analyses are also important to fully understand a company’s performance and future potential.
Why FMCG has high P/E Ratio?
Fast-Moving Consumer Goods (FMCG) companies often have high P/E ratios because they have stable earnings and consistent demand. Investors are willing to pay more for this stability and reliability.
What is a 200 P/E ratio?
This is extremely high and suggests that investors expect very high future growth or the stock is highly overvalued.
Is 42 P/E ratio good?
Whether this is good depends on the industry average and the company’s growth prospects. For some sectors, 42 might be normal, while for others, it could be high.
Is 80 PE ratio good?
This also depends on the industry. It typically indicates high growth expectations.
Additional Resource – P/E Ratio – Definition, Types, Calculation & Limitations