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Price to Earnings (P/E) Ratio
The Price to Earnings ratio is one of the valuation ratios through which we can know whether the stock is undervalued or overvalued. It indicates how expensive or cheap the stock is trading as compared to its peers.
Price to Earnings Ratio= Current Share price/ Earnings Per Share (EPS)
Before we proceed further to understand the P/E ratio, let us first understand what is Earnings per Share (EPS).
Earnings per Share = Net profit/ Total no. of outstanding shares
Where, Total no. of outstanding shares= Market Capitalisation/ Current Share price.
If the company distributes all the profits among the shareholders, how much money a shareholder gets behind a share.
For example, if the share price is Rs 200 and EPS is Rs 10, this means if the company distributes its entire profit between its shareholders, each shareholder gets Rs 10 for holding one share. So, the higher the EPS, the better it is for the shareholders.
Now coming to the P/E ratio, if we divide the current market price of a stock with EPS we get the Price to Earnings ratio of a company. The P/E ratio measures the readiness of the shareholders to pay for the stock, for every unit of profit that the company earns. For example, if the P/E of a company is 23, then it means that for every unit of profit the company earns, the shareholders are ready to pay 23 times. Therefore, the higher the P/E, the more expensive the stock is.
Let us calculate the P/E for Infosys. We know from the annual report-
PAT = Rs.16594Crs
Total Number of Shares = 426
EPS = PAT / Total Number of shares
= 16594 / 426
= Rs.38.95
Current Market Price of Infosys = 1122
Hence P/E = 1122 / 38.95
= 28.8 times
This means for every unit of profit generated by Infosys, the shareholders are ready to pay 28.8 times to acquire the share.
P/E fair or expensive
How can we know whether the P/E ratio of Infosys is fair or expensive?
For this, we have to compare the P/E ratio of Infosys with the P/E ratio of the company in the same industry i.e. IT industry, or compare its P/E ratio with the industry P/E. Industry P/E is the average P/E of all the companies in the industry.
Let us take the example of TCS. The P/E ratio of TCS is 31.8. As compared to TCS the stock of Infosys is cheap/ undervalued.
A lower P/E could be because of so many reasons such as
- Company is undervalued
- The company is performing worse. So the shareholders do not have confidence in the company and they are not investing.
- Some bad news is coming out against the company.
We have to think of if the P/E ratio of a company is low, then why it is low, and vice-versa. A company performs well, fundamentals are good, management is good, future prospects are good and despite this, if the P/E is less, then the company is undervalued. While deciding the valuation of a company through the P/E ratio we have to think of the other factors also i.e. how the company is performing, how can its products and services, and performance be in the future. Also, higher P/E does not necessarily mean the company is expensive; it may be that the company is very amazing that people have a lot of confidence in the company and they want to buy stocks at any price.
Types of P/E ratio
There are two types of P/E ratios: Forward P/E and Trailing P/E.
Forward P/E= Current Share Price/Estimated future earnings over the next 12 months.
We can derive these estimated figures or can get from the reports published by the stock market analysts. The forward P/E is used to find out the expected performance and earnings of a company in the future. If the forward P/E ratio is higher than the current P/E, it shows decreased earnings.
Trailing P/E= Current Share Price/ Earnings per share over the past 12 months.
It is the most commonly used P/E ratio as it gives a more authentic view of the performance of a company.
Limitations
The P/E ratio does not give enough information. It is very difficult to know whether the stock is undervalued or overvalued through its P/E ratio. P/E ratio just gives an overview of the company and the valuation of the company. If you invest in a company just because its P/E is low, then it is not a good decision.
We can analyze the P/E ratio but cannot rely completely on the ratio because it does not give an idea about the company and its future performance. P/E ratio valuation depends on the current performance of the company.
To find the valuation of the company we should know the intrinsic value. The P/E ratio does not give any information about the intrinsic value. We have to use the methods such as Weighted Average Cost of Captial (WACC), EV/EBITDA model, Discounted Cash Flow (DCF), etc. to find the intrinsic value of a company.
Price to Earnings ratio of Nifty
To find the P/E ratio of Nifty, follow the steps below:
- Visit www1.nseindia.com.
- Go to Products and click on Indices.
- Under indices, click on Historical data and under historical data search P/E, P/B & Div Yield values.
- Select the time period and check the P/E box and get the data.
It is assumed that if Nifty P/E is 18, then it is fair, if it is 16 or less, then it is undervalued and if it is 21 or more, then it is overvalued. Be cautious when Nifty P/E is 21 or more. Higher Nifty P/E means the prices of Nifty stocks move a lot faster as compared to the earnings of the Nifty companies.
Also Read: What are financial markets?