P/E Ratio – Explained

P/E ratio stands for ‘Profit-to-Earnings’ ratio. The formula used to calculate P/E ratio is, P/E = ‘Price of the share’ divided by ‘Earnings per Share’.

A high P/E ratio means that the share is overvalued or investors are expecting the company to grow in the coming days.

A low P/E ratio means that the company is undervalued or investors are not expecting the company to grow in the coming days.

The first type of P/E ratio is ‘Forward P/E ratio’. The formula for calculating forward P/E ratio is, Forward P/E ratio = ‘Price of one share’ divided by ‘Forecasted Earnings per share over the period of next 12 months’. Investors use Forward P/E ratio to predict how the company behaves during the upcoming year.

The second type of P/E ratio is ‘Trailing P/E Ratio’. It is calculated as follows, Trailing P/E Ratio = ‘Price of one share’ divided by ‘Earnings per share during the past 12 months’. As we already know the past data, Trailing P/E ratio is considered to be more accurate.

When it comes to value investing, investors compare P/E ratio of peers operating in the same sector. Further an individual company’s P/E ratio is compared with average P/E ratio of the companies operating in the same sector. Investors who understand technical analysis use other technical data along with P/E ratio to time the correct entry. However, it’s not that easy to time the market and hence most investors prefer averaging (you can read more about it in my post called ‘Rupee Cost Averaging’).

Limitations of P/E ratio – As mentioned earlier we use the earnings per share in the denominator, but what if a company is in loss. A company called Zomato went public few months back and though its customers are increasing, the company is still under loss. So calculating P/E ratio of loss making companies is a hurdle as some people consider the denominator to be zero, negative or not available (N/A).

Well that was it for this post, before closing the tab do checkout my other posts. See you next time with a different post. Byeee 🙂

Disclaimer : Trading stocks is subjected to market risks. Please read all the terms and conditions before investing. The motive of this post was to teach little things about stocks for those who do not understand much about stocks. Candidcanblog.com will not hold any responsibility for any losses incurred to the readers of this post.