What is PE ratio?
Since trading in the stock market has been a recognisable part of financial trade in the Middle Ages in Europe, traders have developed various measures of valuation. This was done in order to able to gauge how much they should invest to receive the desirable profit. Over the course of its evolution, stock market trade has been measured using a variety of indicators, such as the Japanese candlestick pattern, the Dow average, and indicators such as RSI. Traders in modern times generally use a mixture of different principles and indicators in order to reach results as favourable as possible. P/E ratio is one of many such indicators.
Definition of PE Ratio
Before we discuss the types of P/E ratio, we first need to understand what it is. P/E ratio stands for the Price-to-Earnings ratio of a stock. It is a measure in which the market price of a company’s stock and the actual earnings from that stock are compared. P/E ratio is a method of stock valuation which has a number of variations. The P/E ratio is calculated as given below:
P/E= Share Price/EPS, where:
P/E= Price-to-Earnings ratio
Share Price = Market value of per share
EPS = Earnings per share
This simple P/E ratio formula can be modified in order to calculate the stock’s value. Variations are as given below.
Variations of the P/E Ratio:
The P/E ratio has three main variations. These are:
- Forward P/E ratio, where the stock’s value is calculated by dividing the current stock price with the estimated future earnings of a company. This variation is also known as the estimated P/E ratio.
- Trailing P/E ratio is a variation in which stock value is calculated by dividing the current stock price with a company’s earnings for the past twelve months. This variation is favoured by most companies and investors as it includes actual financial data in its calculation.
- The average P/E ratio is the third variation of the P/E ratio. More commonly known as the Shiller P/E ratio, the stock value here is calculated by dividing the current stock price with the average earnings of a company for the preceding ten years.
Additional Read: Ratio Analysis Techniques to Use while Picking Stocks
Usage of PE Ratio
The P/E ratio is used by investors for the following purposes:
- The primary use of the P/E ratio is in the determination of a company’s stock value by investors. This can help determine whether a stock is overvalued or undervalued.
- Investors use the P/E ratio in order to gauge a company’s competitiveness vis a vis its contemporaries in the particular economic segment it occupies.
- P/E ratio is also used to gauge the amount an investor should invest in a company and the best time to do so.
Limitations of Price to Earnings Ratio
Though it is a useful tool, the P/E ratio has some limitations. These include:
- While the P/E ratio can provide an estimate based on past earnings or estimates of future earnings, it cannot accurately predict the performance of any stock over a longer period of time.
- P/E ratio does not factor in the EPS growth rate of a company.
- P/E ratio cannot be used to compare the potential of companies from different sectors.
The PE ratio is one of the key metrics in determining the value of stock, that is, whether it is undervalued or overvalued. While being an important indicator, the P/E ratio’s limitations only make it suitable as part of a larger set of indicators. These indicators can then be used in combination to better understand the investment potential of a company. However, investors should avoid basing their investment decisions solely on the P/E ratio.
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