What is Price-to-Earning (P/E) Ratio in the Share Market? (2023)

PE ratio, also called the price-to-earnings ratio, is one of the significant metrics used to measure the value of a company’s stock and the returns investors can expect from it. 

This ratio can be used to compare a company’s stock with other companies falling in the same industries and level to determine which is performing and growing well under existing market conditions. 

If you are a stock trader, investor, or aspiring investor in the stock market, it's important to understand “what is P/E ratio and how you can use it to make accurate investment decisions.”

What is Price-to-Earning (P/E) Ratio in the Share Market?

P/E, or Price to Earning Ratio, is a ratio that shows the relationship between the current price of a company’s stock and earnings per share or the earnings that investors can expect from the share. This ratio can be calculated based on historical data (to know trailing PE) and forward-looking (to know forward PE). 

After calculating price to earning ratio, investors can use this ratio to: 

1. Compare prices of stock with other companies within the same industry and size.

2. Measure if stock is under, over, or properly priced in the market.

3. Decide if the stock is good for buying, selling, or holding for a long time.

Knowing about the PE ratio can sound a little tricky and technical but actually it's one of the simplest ratios to know the stock prices of a company and the expected returns on investment. 

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PE Ratio Calculation with an Example

Let’s understand the price-to-earn ratio with an example and discuss the P/E ratio formula so you can use it for further analysis. 

P/E Ratio Formula: Current Price of Company’s Share/Earning Per Share

Here,

The current Price of the Company’s Share means the current trading price of the company’s share in the stock market or the per share cost investors need to pay to buy the share of the company.

Earning Per Share refers to the net profit of the company that it records in the books of the final account, divided by the total number of outstanding shares it has issued. 

Now, you know the formula or PE ratio, let’s understand how you can use it to calculate the PE ratio of selected stock in the share market. 

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PE Ratio Example: 

Suppose company ABC’s stock price in the share market is Rs10 per share, which records a net profit of 15,000, and the company's total number of outstanding shares is 10000. Calculate the PE Ratio of ABC. 

P/E Ratio = Cost of Share (or Current Price of Company’s Stock)/EPS (Earning Per Share)

We have,

Cost of Share = Rs 10

But we need to calculate the EPS.

The formula of EPS = Net Profit/Number of Total Outstanding Shares

= Rs 15,000/Rs 10,000

= Rs 1.5

Now we also have EPS of Rs 1.5

Let’s put the value into the given formula.

P/E Ratio = 10/1.5 = 6.66 Times

A PE Ratio of 6.66 Times means that the investors are willing to pay 6.66 times higher for the shares to avail of an opportunity to earn a similar proportion of profit.

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What are the Types of P/E Ratios?

There are primarily two types of PE ratios: Trailing and Forward PE ratios. Below I have explained both so that you can understand their purposes and use cases.

1. Trailing PE Ratio

The trailing PE (TPE or trailing price-to-earnings ratio) ratio uses the current price of the company’s share and the company’s net profit recorded in the past 12 months. This analysis is common among investors who frequently invest in the stock market. 

It also gives accurate information about a company’s performance as long as they provide financial information correctly and honestly in their books of account. Most importantly, Trailing PE analysis utilizes concrete data instead of subjective or projected data for a calculator. 

2. Forward PE Ratio

The forward PE (FPE or forward price-to-earnings) ratio uses the predicted earnings per share instead of record earnings within the last 12 months. 

Investors analyze this ratio because the previous data not only gives clear information about the company’s performance, but they also have to forecast to understand how much return the selected share can offer in a given time. The forward price-to-earnings ratio mainly relies on the estimation by financial experts. 

There are certain limitations of the FPE ratio because the company can underestimate its future returns while announcing its quarterly gains, or it may also overestimate to increase the prices of its shares. 

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What is a Good P/E Ratio?

No fixed benchmark figure represents a good P/E ratio, but the 20 to 25 PE ratio is considered satisfactory. 

It’s a comparison tool that helps investors derive much information about stock and compare its performance with other companies of the same size and industry. 

Using the PE ratio, you can determine if the share is underpriced, overpriced, or properly priced in the market. However, if you want to get better insights, it's better to explore other tools that count the price movement and changes that have a direct impact on PE ratio calculation.

Pros of P/E Ratio

1. Help in understanding and comparing the company’s stock price and expected returns.

2. Give enough information if stock is under or overpriced in the market.

3. PE ratio is easy to calculate and get help in making an investment decision.

4. It briefly explains how much other investors are willing to pay for the shares.

5. Higher PE indicates the growth of the company and future earnings.

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Cons of P/E Ratio

1. The ratio does not include the EPS growth rate of the respective company

2. The EPS of stock is announced every quarter, but the stock prices fluctuate daily. 

3. Comparing the PE ratio of two companies in different industries may leave room for many errors.

4. PE ratios do not reflect complete information about a company’s yearly performance involving external factors like economic conditions. 

Conclusion

P/E, or Price-to-Earning ratio, is a kind of ratio that shows the relationship between the current prices of stocks and EPS. It’s an important metric widely used by investors and stock traders to understand whether the stock is undervalued and predict future returns. 

However, the PE ratio is not a foolproof metric to employ blindly. While using the price-to-earnings ratio, it's also important to consider other stock trading techniques and information to make the right buying and selling decisions. 

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