What Is PE (Price to Earning) Ratio? Definition, Meaning & How to Interpret It

Say you want to compare the stocks of two companies – Company A and Company B, which are a part of the automobile industry, to invest in.

The per share price of Company A is Rs. 100. The price per share of Company B is Rs. 150. But, this does not mean Company A is a better investment just because it is cheaper.

A low share price does not mean the company is undervalued. It’s only undervalued when the price of the share is low relative to the amount of money the company is making.

To evaluate Company A and Company B, you need a common measurement.

This standard measurement is the PE Ratio. The Price-to-Earnings ratio is one of the most important parameters for stock valuation.

What is PE Ratio?

The price-to-earnings (PE) ratio of a company is a metric that compares the market price of a stock to its earnings per share. It is also called the earnings multiple or the price multiple. Essentially, the PE ratio of a company tells us how much money an investor in the market is willing to pay for one rupee of the company’s earnings.

PE Ratio Formula

Calculating the PE ratio of a company is simple. You need to divide the company’s current market price by its Earnings per share (EPS).

PE ratio = Market Price/ EPS

Now, for the same companies, let’s evaluate the PE Ratio – 

So, from the above table, we understand that if you purchase the shares of Company A, you will have to pay ten times the earnings. But for Company B, you will need to pay 30 times the earnings! The stocks of Company A seem undervalued and a better investment choice between the two. However, you also need to compare growth and other parameters before making any investment decision.

The lower the PE Ratio, the better it is for their potential investors.  Companies with high PE ratios are considered suitable investments if they have justifiable high growth estimates.

Types of Price-to-Earnings (PE) Ratio

We have the following types of PE ratio – Absolute PE ratio, Relative PE ratio, Forward PE Ratio, Trailing PE Ratio, Index PE ratio and Sector PE ratio.

Let's understand them all.

Absolute PE ratio:

It is the PE ratio of an individual stock and can be calculated by dividing the market price by the recent 12-month EPS of a stock. As the PE ratio is a valuation ratio, the absolute PE ratio does not give any information. It must be compared with the PE of similar companies or sector PE.

Relative PE ratio:

It compares the PE ratio of a stock with the sector PE or PE of similar companies. If a stock PE is more than the sector PE, it means it is trading at a premium compared to its peers. The premium may be due to the higher growth potential of a stock or the stock is overvalued.

Forward PE Ratio:

It is based on a company's future earnings. It is determined by dividing stock prices by the expected future EPS. Analysts usually use the forward PE for better and more realistic future-price estimation.

Trailing PE Ratio:

This is based on a company's earnings over the past 12 months. It is measured by dividing the stock prices by the past year's EPS.

Index PE ratio:

Any index like Nifty 50 or Sensex's PE ratio can also be calculated. It is the weighted average of all the index stocks. Index PE is used to see whether the market is overvalued, undervalued or fairly valued compared to its historical PE ratio.

Sector PE ratio:

The Sector PE ratio can also be calculated by the average of all the companies in that sector. If an index is available for a particular sector, sectoral index PE can be used for comparison.

What is the Nifty 50 Price-to-Earnings (PE) Ratio? 

The Nifty 50 PE ratio is a metric that tells you how the index is valued. Historically, the Nifty 50 PE ratio has averaged around 20. Any value above 25 indicates that the index is costly. It may be best to book profits and enter again when the market falls in such a situation. 

When the index goes above 25, the market may be headed for a correction. For instance, before the 2008 market crash, the PE ratio of Nifty 50 was around 28. From there, it took a steep crash. Knowing when to exit the market using the PE ratio could be a good strategy for an intelligent investor.

If the PE ratio of Nifty 50 is below 15, the index is undervalued. You can expect the stocks in the index to bounce back shortly. This may be a good time to buy shares in the index and book profit later. However, it doesn’t mean it will crash or bounce immediately on reaching the threshold level. So, Nifty may also continue to trade at a lower or higher PE ratio for an extended period. Besides, threshold levels like 25 or 15 will not always hold good; the market may also trade at a higher and lower PE ratio.

Historical Nifty 50 PE trend

The nifty 50 PE ratio keeps fluctuating due to market volatility. During the bull run, Nifty 50 PE often exceeds its historical average and indicates expensive markets. Similarly, in bearish markets, it tends to go below its historical average and indicates buying opportunity.

Below is the Nifty 50 PE historical chart and its value. You can see how the Nifty PE fluctuates over a period, and it peaks in Feb 2021 when it crosses the 41 level and makes a low below 12 in Oct 2008.

Source: trendlyne.com

How to Calculate the Nifty 50 PE Ratio?

According to market capitalization, the top 50 Indian companies make up the Nifty 50 index. When calculating the PE of an individual company, you can divide the company’s market price by its EPS. 

To calculate the PE ratio of the Nifty 50 index, you need to take the weighted average of the PE of all the index constituent stocks. This will give you the PE ratio of the index. As mentioned before, the index is considered reasonably valued as long as the PE ratio of Nifty 50 is within the range. If the ratio moves up or down, you can change your investment strategy accordingly, often with the assistance of a stock trading app. 

What is a good PE ratio?

There is no definition of a good PE. The PE ratio is a relative parameter that must be compared with similar stocks or sectors. Also, the PE ratio depends on the future growth prospects of a company. Companies with a higher growth potential usually trade a higher PE ratio and companies with a poor growth rate command a low PE ratio. However, based on the current PE ratio, one can take a cue from the historical trend to understand whether the stock is expensive, undervalued or fairly valued.

Limitation of PE ratio

Considers only earnings and price:

The value of the PE is highly dependent on the movement of a stock's price and the company's earnings. This means that the ratio could potentially move up or down even if the stock price remains unchanged, depending on the increase or decrease in earnings.

Growth is not factored in:

PE ratio does not consider the growth rate of a company. Companies with a higher growth rate usually trade at a higher PE ratio and vice versa.

Comparable ratio:

The PE ratio is a comparable ratio and the absolute number doesn't give any idea about the valuation of the stock. It always needs to be compared with peer group companies to get some meaningful insights.

Different PE ranges for various sectors:

Stocks of different sectors trade in different ranges depending on the stability of the earnings, growth factor, etc., and one can't compare the PE of the stocks of different sectors.

Always use other indicators along with PE:

The PE ratio is just one of the metrics available to traders and investors. Using two or more metrics to determine whether the market is overbought or oversold is always better. 

Conclusion

The PE ratio is a metric used to understand the valuation of a particular sector, index or stock. You can also compare the PE ratio of individual companies against the PE ratio of the respective index to understand how a company performs compared to its index. The PE ratio is a comparable metric, and absolute value does not give any significant insight about a stock's valuation. It is always better to use 2-3 valuation ratios like Price to Book value (P/BV), Enterprise Value to EBITDA ( EV/EBITDA), Price Earnings to Growth ( PEG), etc., to make informed decisions. You can look at the following images to learn more about other popular valuation ratios.

FAQs About PE Ratio

1. What is the PE ratio in the share market?

The price-to-earnings ratio of a company is a metric that compares the market price of a stock to its earnings per share. Essentially, the PE ratio of a company tells us how much money an investor in the market is willing to pay for one rupee of the company’s earnings

2. What is the formula of the PE ratio?

Calculating the PE ratio of a company is simple. You need to divide the company’s current market price by its Earnings per share (EPS).

PE ratio = Market Price/ EPS

3. What is a good PE ratio?

A good PE ratio can vary depending on various factors. You can see the historic PE value to get a reference of the range and compare it with the current value. However, it is wise to assess all other aspects and market conditions.

4. What is the PE ratio in options?

In options trading, the PE ratio is not directly applicable as they ideally do not have earnings like in stock trading. Instead, options traders often use metrics such as implied volatility, time decay, and the option's intrinsic and extrinsic value.

5. Which PE ratio is good, high or low?

There is no high or low PE ratio. It must always be compared with similar companies and other relevant metrics to arrive at any conclusion.

6. Should I buy stocks with a high PE ratio?

A high PE ratio is typically justified if a stock is in a high-earning growth trajectory. However, high growth also comes with a risk, and one needs to be aware of this. However, high PE without any significantly higher growth is not justifiable.

7. Is a negative PE ratio good?

In most cases, a negative PE ratio is not considered suitable for companies with a decent operating history as it suggests that the company is making negative earnings and not generating profits. However, there are exceptions where the PE ratio might not fully capture the potential, such as when companies are in their high-growth phases or new-age companies, which may take some time to show profits.