The search for stocks with long-term growth potential is a common one for investors and traders. There are different metrics typically used for identifying the growth potential, and a popular one among those is the price earnings ratio (P/E ratio). It basically indicates the valuation of a stock relative to its earnings. This helps investors answer the important questions – Are the shares overpriced? Are they undervalued? Or are they priced fairly?
In this article, we are going to explore price earnings ratio, the insights it provides, and more. Read along!
What is the Price Earnings Ratio?
The price earnings ratio is a valuation measure that equates a company’s current share price to its earnings per share (EPS). It basically indicates how much investors are ready to pay for Re. 1 of company earnings.
P/E Ratio = Current Market Price of Share ÷ Earnings Per Share
For example, if a company’s P/E ratio is 30, it means investors are willing to invest Rs. 30 in its stock for every Re. 1 of earnings. A high P/E ratio can indicate either strong growth expectations or overvaluation. On the contrary, a low P/E ratio may suggest undervaluation or weak future performance.
How the Price Earnings Ratio Works
Price earnings ratio assists investors in determining the relative worth of the stock. A high ratio tends to indicate optimism for growth in future earnings, raising stock prices as a result of heightened demand by analysts and investors. A low P/E ratio may signify the scepticism of the market regarding the future earnings of a company. It may also identify a company whose stock is undervalued at present.
Types of Price Earnings Ratio
Various P/E ratio types are important in accurate analysis:
Forward P/E Ratio
The forward P/E ratio is determined by a stock’s current price divided by its forecasted future earnings per share. Also referred to as the estimated P/E, it comes from projections made by the company and provides insight into future performance and growth. This ratio is usually used by investors when analysing companies that are likely to undergo considerable changes in terms of earnings.
Trailing P/E Ratio
Trailing P/E ratio takes into consideration the previous earnings of a company, typically for the past four quarters. It shows a company’s performance in the past and is mostly applied to established companies with stable previous earnings. Using the current share prices versus previous earnings, investors can see how the market determines the value of prior performance.
Absolute vs. Relative P/E Ratio
The absolute P/E ratio compares a stock’s prevailing market price to its earnings per share. For instance, if a firm is Rs. 200 per share with an earnings per share of Rs. 20, the absolute P/E is 10. In contrast, the relative P/E ratio compares a company’s prevailing P/E against its past average or its peers in the same industry, giving insights into a stock’s overvaluation or undervaluation relative to the benchmarks.
Interpreting the Price Earnings Ratio
It is important to interpret price earnings ratio correctly is key to understanding a company’s valuation, growth potential, and relative standing in the market.
Valuation Indicator
The P/E ratio is an important valuation indicator. A high P/E ratio can mean that the stock is comparatively pricey. Alternatively, a low P/E ratio could be a pointer to undervaluation or reduced growth prospects, something that may be a buying opportunity.
Comparing Companies
The P/E ratio often helps investors compare companies within the same sector or industry. For instance, a lower P/E ratio than peers points to undervaluation and a higher ratio to overvaluation.
Growth Expectations
The P/E ratio also captures market expectations of future earnings growth. A lower ratio suggests slower growth expectations. It can also be concerned over the company’s ability to generate steady earnings.
Historical Context
Comparison of the current P/E ratio with the historical range can show whether the stock is trading below or above the average.
Using the Price Earnings Ratio in Investment Strategies
The P/E ratio can guide both value and growth investing approaches:
| Strategy | How it Works |
| Low P/E Strategy | Focuses on value investing by identifying stocks trading below sector or market averages. |
| High P/E Strategy | Aligns with growth investing, targeting companies expected to deliver strong future earnings. |
| Relative P/E Analysis | Helps rotate investments across sectors and identify optimal entry or exit points. |
Limitations of the Price Earnings Ratio
Even though price earnings ratio is a very helpful tool, it is not without limitations:
- Limited Information: It is not a full picture of a company’s financial well-being. It does not reflect debt levels.
- Industry Differences: P/E ratios across various industries can be quite different. Industry-specific comparison is required.
- Manipulation of Earnings: Reported earnings can be manipulated. P/E ratio based on false reports will be unreliable.
- Cyclical Effects: Cyclical or seasonal revenues can cause P/E readings to inflate.
Conclusion
When investors are trying to identify stocks positioned for long-term growth, price earnings ratio insights can be of great use. By analysing a stock’s price relative to earnings, reviewing past trends, and looking at industry and growth variables, investors can make better and more confident choices.