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PE Ratio is one of the most widely used financial ratios for evaluating the valuation of stocks. From Benjamin Graham’s Era to the current world, the essence of the PE ratio hasn’t changed. Although the PE ratio is a simple evaluation tool for stocks, however, it can be difficult to interpret for beginners.

In this article, we are going to discuss how you can use the Price to Earnings (PE) ratio the right way for comparing stocks. Further, we’ll also be discussing how ‘not’ to use PE ratio. Keep Reading!

What is Price to Earnings or PE Ratio?

Just looking at the share price of a company makes no sense. Stocks can trade at any share price and it tells you nothing about the valuation of a company. A stock with Rs 2,000 as its share price can be undervalued and another stock with a share price of Rs 100 can be overvalued.

For example, Apollo Tyres is currently trading at a market price of Rs 221.80. What can you tell about the valuation of Apollo Tyres? Is it cheap or expensive?

Even if you are given two stocks and their share price, you cannot judge which one is under-valued and which one is over-valued. For example, here are the share prices of two tyre manufacturing companies:

MRF Tyres (Rs 80,085.35);
Apollo Tyres (Rs 221.80)


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Here, you cannot say that MRF Tyres is way overpriced just because its current market price is a lot bigger than that of Apollo Tyres.

The biggest problem while comparing companies based on share price is that the companies have different numbers of outstanding shares. The total number of shares trading for any specific company may not be the same as another company. That’s why we need more relevant tools for comparing stocks. Enter PE Ratio.

One of the simplest tools that the investors are using to evaluate stocks is Price to Earnings ratio.

From the name itself, you can explicate that it measures the market price of a company’s stock relative to its earnings. The best part is that the PE ratio of a company can be compared with that of other companies, unlike their current market price.

Here is an example of two companies- A and B from the IT sector.

ParticularCompany ACompany B
Earnings Per Share (EPS)2020
Current Market Price Per Share450650
Price to Earnings (PE) Ratio22.532.5

In the above table, you can notice that with the same earnings, company B is trading at a higher share price. Therefore, here we can say that company B is overvalued.

As a thumb rule, while comparing the PE ratio of two companies, the company with lower PE ratio can be considered undervalued. On the other hand, companies with higher PE ratio are over-valued.

Nevertheless, the comparison should be apple-to-apple. Comparing apple-to-oranges makes no sense. What we mean by the apple-to-apple comparison is that both the companies should be from the same industry. A banking company should be compared to another banking company while looking into PE ratio. However, comparing the PE Ratio of a banking company with an automobile company will not make much sense.

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Also read:How to do the Relative Valuation of stocks?

How to calculate PE ratio?

The formula to calculate Price to earnings ratio is:

PE ratio = Price per share/ Earnings per share.

Most times, the last 4 quarters’ earnings (Trailing Twelve Months-TTM EPS) are taken as the annual EPS of a company while calculating PE. This is called trailing earnings as the past performance of the earnings is considered here.

NOTE: Trailing PE ratio is dynamic. It keeps on changing as the market stock price of the company consistently changes day-to-day. On the other hand, the earnings of the company are released every quarter.

As we are using the current market price and past earnings per share, the trailing PE ratio might show some higher value. That’s why some investors prefer ‘forward PE’ or ‘leading PE’.

Here investors use projected future earnings. The earnings of the company for the next 12 months are estimated for calculating the PE ratio here.

If forward PE is less than the trailing PE, this means that the EPS will increase in the future. On the contrary, if forward PE is greater than the trailing PE means that the EPS will decline for that company.

Further, often the investors also find the historical average PE ratio of the stock to compare it with the current PE ratio. Let’s say, you find the average yearly PE ratio for the last 5 consecutive years for a company. By comparing the current PE ratio with the historical PE ratio, you can evaluate whether the company currently has higher or lower PE i.e. whether the company is overpriced or underpriced, based on its own history.

Further, please note that there may be few companies with zero profit or negative earnings. In such scenarios, the PE ratio doesn’t exist. The price to earnings ratio is not interpretable for a non-profit making company (until the company becomes profitable).

Quick note: PEG Ratio

While learning PE ratio, it’s also wise to understand the PEG ratio, another popular financial ratio for valuing stocks.

PEG ratio or Price to Earnings to Growth ratio is used to find the value of a stock by taking into consideration the company’s earnings growth. This ratio is considered to be more useful than the PE ratio as the PE ratio completely ignores the company’s growth rate.

PEG ratio can be calculated using this formula:

PEG ratio = (PE ratio/ Projected annual growth in earnings)

As a thumb rule, stocks with a PEG ratio less than 1 or lower are considered undervalued relative to their EPS growth rates, whereas those with ratios of more than 1 are considered overvalued.

Also read: #19 Most Important Financial Ratios for Investors

How to use PE ratio- The right way?

Theoretically, the PE ratio tells how much investors are willing to pay against per share of earnings of that company.

For example, if the PE ratio of a company is 30, it means that the investors are willing to pay Rs 30 per share, for the earnings of Rs 1. That’s why a lower PE ratio is preferred. It means that you are paying less to buy the stock of the company for its per-share earning of Rs 1.

Overall, PE ratio tells whether the company is trading at a premium or discount.

Now, you should always compare the PE ratio of the companies in the same industry (Apple-to-Apple comparison)

The average PE ratio of the companies varies from industry to industry as some industries may involve higher earnings than others. This difference in the PE ratio may be because the market values one industry more than the other, depending on its growth rate, business potential, etc.

For example, let’s compare the PE ratios of companies from two different industries.

Here is the PE ratio of companies from the Refinery and Oil Exploration Industry

Refinery and oil exploration industry

And here is the PE ratio of companies from the Household & Personal care industry:

household and personal products industry

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You can notice here that the PE ratio of most of the companies in Oil and gas industry is less than 15 (Except Reliance that operates in Multiple Businesses) and that of FMCG & Personal care is greater than 50.

Therefore, if you compare the PE of a company from the Refinery industry to that of another company in the Personal care industry, you will always find the oil and gas company cheaper. If you follow this apple-to-orange comparison approach, you will never be able to buy ‘apples’. That’s why PE comparison should always be in the same industry.

Further, there’s no universal thumb rule for the PE ratio. For example, you cannot consider companies with PE less than 25 as undervalued in all Industry. For some industry, the average PE might be less than 25 and for others, the average might be greater than 25.

In short, while evaluating the companies based on PE ratio, always compare the company with its competitor or the industry average. If the PE of a company is less than its competitors and the industry average, then it can be considered as undervalued.

Loopholes while using PE ratio:

While comparing PE ratio, low PE doesn’t ALWAYS mean that the company is a good investment.

There may be some valid reasons why the market is hammering that company. For example, the company’s business might be declining. Or the investors can notice financial trouble for the company in future. Further, there might not be any growth opportunity for that company, and that’s why investors are disliking the company and it is trading at a low PE. Low PE ratio might be considered as a discount. However, discount products are not always good.

Further, for a high PE ratio company, the investors might be looking at a high growth in the future and increase in earnings of the company. That’s why they might be willing to pay a premium to buy that stock. As mentioned earlier, the biggest drawback of using the PE ratio alone is that it doesn’t consider the growth aspects of the company.

Also read: Why Nobody Talks About VALUE TRAP? -The Bargain Hunter Dilemma

Conclusion

PE ratio is a simple and effective fundamental tool that gives a lot of information about the company’s valuation. However, there are a few drawbacks when using the PE ratio as a single deciding factor while investing in stocks.

While evaluating the PE ratio, always compare the PE of a company with the other companies in the same industry. You can also compare the current PE of the stock with that of industry average PE, Index PE, or the company’s own historical PE ratios.

That’s all for this post on the basics of PE Ratio Analysis. We hope this post was useful to you. Have a great day and Happy Investing.