Price to Earnings (P/E) Ratio: Types, Formula and Examples

In the world of investing, everyone wants a piece of the profits. But how much are you willing to pay for that slice of profits? Is there a metric to measure it? Enter Price-to-Earnings ratio or the PE ratio.This is one of the most common metrics used to compare companies in the same industry to pick out a better performer, along with other considerations. So, what is the PE Ratio, or price-to-earnings ratio, and why is it so important for investors? This blog provides answers to these questions and more on the PE ratio.

What is a Price to Earnings (P/E) Ratio?

The price-to-earnings ratio, or PE ratio, is a key financial metric that helps investors determine the relative value of a company's shares. It measures or compares the market price of a company's shares to its earnings.

This ratio helps determine what investors will pay for each rupee of the company's earnings. The PE ratio can be used as a yardstick to compare the company’s performance to its peers or against the industry benchmark and assess whether the shares are undervalued or overvalued. 

How to Calculate P/E Ratio?

The calculation of the PE ratio requires the use of two important components for stock evaluation, the current market price per share and earnings per share. 

You can get the current market price of the shares can from the stock market websites or financial news. 

P/E Ratio Formula

You can calculate The PE or Price-to-earnings ratios using different formulas depending on the available data and context. 

PE Ratio = Market Price Per Share (MPS) / Earnings Per Share (EPS)

Or 

PE Ratio = Market Capitalisation / Total Net Earnings

Examples for Calculation of P/E Ratio

Here is a brief example of PE ratio to understand the concept better.

Consider Company A with the current stock price of Rs. 500 per share and reported EPS of Rs. 20 per share. The PE ratio for Company A can be calculated as under,

PE Ratio = Current Market Price / Earnings Per Share

PE Ratio = 500/20 = 25

Types of P/E Ratio

Some of the commonly used PE ratios are-  

Trailing PE Ratio

The trailing P/E ratio uses earnings per share (EPS) from the past 12 months (trailing twelve months, TTM). This is the most commonly used P/E ratio based on historical data, making it a reliable indicator of past performance. This ratio helps understand how much the shareholders pay for each rupee of earnings the company has already generated. The formula to calculate the trailing PE ratio is,

Trailing PE Ratio = Current Market Price per Share / EPS from the past 12 months

Forward PE Ratio

The forward P/E ratio uses the projected earnings per share for the next 12 months. This ratio is based on future earnings estimates and is helpful in assessing a company's growth potential. It helps investors decide whether a stock if the price is rightly valued based on its anticipated performance. The formula to calculate the forward PE Ratio is,

Forward PE Ratio = Current Market Price per Share / Projected EPS for the next 12 months

Relative PE Ratio

The relative P/E ratio compares the P/E ratio of a specific stock to the P/E ratio of the market or its sector. Investors use the P/E ratio to determine whether a stock is overvalued or undervalued compared to its peers. A higher relative P/E ratio might signal an overvalued stock in relation to the market or its sector. The formula to calculate the relative PE Ratio is,

Relative PE ratio = PE Ratio of the stock / PE Ratio of the Market or Sector 

What Is the Difference Between Forward P/E and Trailing P/E?

The difference between Forward P/E and Trailing P/E lies in the timeframe of earnings used for calculation.

Trailing P/E, or historical P/E, uses the company's past earnings over the last twelve months to determine the ratio. It reflects how much investors are willing to pay for past earnings. 

In contrast, Forward P/E uses estimated future earnings per share (EPS) projected by analysts for the upcoming twelve months. This ratio gives investors an idea of the market price of the stock relative to expected future earnings. 

Forward P/E is helpful in assessing whether a stock is undervalued or overvalued based on anticipated future performance, while Trailing P/E provides a snapshot of past financial health.

Limitations to the P/E Ratio

The PE Ratio is among the most popular financial metrics investors and analysts use. However, investors should consider a few limitations when using it. 

The key limitation of the PE ratio is that it does not account for the quality of earnings, whether they are sustainable or volatile, or the company's growth prospects. 

A high PE ratio usually indicates growth potential but can also suggest that the stock is overvalued. 

Furthermore, there is no standard PE ratio or one-size-fits-all for an industry, making it challenging to compare companies across different sectors. The PE Ratio can also be manipulated by inflating earnings through one-time events or accounting practices that don't reflect a company's true health or have no meaning in the case of negative EPS. 

Therefore, the PE ratio should not be used in isolation for investment decisions; investors should consider other factors, such as growth potential, industry trends, and overall market conditions.  

Conclusion

The price-to-earnings ratio is a valuable tool for investors to assess the relative valuation of stocks. While PE ratios provide a quick gauge of how much investors pay per unit of earnings, they do have limitations, including dependence on historical earnings and the potential for misleading comparisons. Therefore, although the PE ratio is an important measure of the stock analysis, it should be used with other parameters to provide more context to the analysis.