PE Ratio - Price to Earnings Ratio | Types of PE relationships, formulas and constraints (2023)

The P/L ratio, or price-earnings ratio, is the relationship between a company's current stock price and its earnings per share (EPS). Analysts and investors may consider returns from different time periods to calculate this index; However, the most commonly used variable is a company's earnings over the past 12 months or one year. It is also known as the win multiplier prize multiplier.

P/L Ratio Formula

P/E = (current market price of a share / earnings per share)

The price-earnings ratio is one of the most used metrics by analysts and investors around the world. It means the amount of money an investor is willing to invest in a single share of a company for Re. 1 of your earnings.

For example, if a company has a P/E of 20, investors are willing to pay Rs. 20 on your shares for Re. 1 of your current income.

So if a company has a high P/E, it means the company is overvalued or on a growth trajectory. Another interpretation of a high price-earnings ratio could be that such a company is likely to generate higher profits in the future and speculation about this by analysts and investors has caused its current share prices to rise.

On the other hand, a low price-earnings ratio means that the stock is undervalued due to systematic or unsystematic market risk.

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Another interpretation of a low P/E ratio could also mean that a company will perform poorly in the future due to the current decline in stock prices.

Types of price-earnings relationships

Basically, there are two types of P/E ratios that investors consider: the forward P/E ratio and the trailing P/E ratio. Both types of price-earnings ratio depend on the type of earnings, as listed below:

  • P/L Advance Ratio

It is calculated by dividing a company's prices for a single storage unit and a company's estimated profit, which is derived from its future profit forecast. Because this ratio is based on a company's future earnings, it is also known as the estimated P/E ratio.

Investors use the expected price-earnings ratio to assess how a company should perform in the future and what the estimated growth rate is.

  • P/G final

The moving P/L ratio is the most used metric by investors; which analyzes a company's past earnings over a period of time. It provides a more accurate and objective view of a company's performance.

Relationship Between P/L Ratio and Value Investing

Investors who apply “value investing” principles when conducting transactionsstock ExchangeLook at the intrinsic value of a company's underlying assets rather than their current market price.

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The price-earnings ratio is one of the most important metrics in this regard, as it helps determine if a stock is a good one.overvalued stocksoundervalued stocks.

When a company has a high P/E, it means that the company's share prices are relatively higher than its earnings and therefore may be overvalued. Value investors avoid trading overvalued stocks, as this indicates high speculation, making the company vulnerable to systematic risk from inefficient fund management. This approach allows investors to avoid a value trap.

On the other hand, if a stock has a below-average P/E ratio, it means that stock prices are hurt relative to the company's earnings and are therefore undervalued. Value investors see this scenario as a positive indicator to invest in because they can buy these shares at a lower price relative to their intrinsic value and then sell them at a higher value if the prices of these shares rise.

Value investing requires holding stocks for the long term to allow investors to take full advantage of their returns. It's also important to note that people should consider the average P/E of the industry to which a particular company belongs before deciding whether its stock is overvalued or undervalued.

Absolute P/U and relative P/U

There are two other types of P/E ratios that help determine a company's performance.

  • Absolute P/E Ratio

It refers to the traditional price-earnings ratio of dividing a company's current share price by past or future earnings.

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  • Familiares KGV

When calculating relative P/E ratios, a company's absolute ratio is compared to a benchmark P/E ratio or previous price-to-earnings ratios for that company.

Investors use it to determine a company's performance relative to its past indices or benchmark indices. For example, if a company's relative P/E ratio is 90% compared to a benchmark P/E ratio, that means the company's absolute ratio is below the benchmark ratio. On the other hand, a P/E greater than 100% indicates that a company has outperformed the benchmark over the specified period.

What is a good P/E ratio?

One question that baffles investors when using P/E to decide where to invest is what is considered a good or safe ratio. However, it is important to note that the quality of an index will vary based on current market conditions, the industry average P/E ratio, the type of industry, etc.

Therefore, when evaluating different price-earnings ratios, investors should consider the performance of other companies in the same industry with similar characteristics and at the same stage of growth.

For example, if Company A has a P/E ratio of 40% and Company B, with similar characteristics in the same industry, has a ratio of 10%, this essentially means that Company A's shareholders must pay Rs. 40 for order no. 1 of its income and the shareholders of Company B are required to pay Rs. 10 for item no. 1 of your winnings. Therefore, investing in company B may be more profitable in this case.

While high ratios represent the risk of investing in value traps, lower ratios can indicate a company is underperforming due to internal failures.

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As such, there is no foolproof price-earnings ratio that investors can rely on when investing in the stock market. In this sense, other technical analysis indicators such as discounted cash flow, the weighted average cost of capital, etc. can be used to determine the potential profitability of a company.

P/E limitations

While a fair estimate of whether a company's stock is overvalued or undervalued can be made by looking at its price-earnings ratio, it's still prone to error.

The P/E calculation does not take into account a company's EPS growth rate, so investors also use the PEG ratio, or price/earnings/growth ratio, to decide which company is most promising.

Another reason why the P/E cannot be used solely to make an investment decision is that a company's earnings are released every quarter, while stock prices fluctuate daily. As such, the P/E may not match a company's performance for very long, leaving investors a wide margin of error.

Therefore, investors should never decide whether a company is worth investing in based solely on price-earnings. You also need to consider a number of other factors that greatly affect the actual value of the stock. These include: whether the company's particular industry is facing an economic downturn or experiencing a cyclical boom, the company's past records, the size of the company (large, mid, or small cap), EPS growth prospects , the industry to which the company belongs. in audience, average P/E in the stock market, how companies of a similar size are doing, specific industry demand now and in the future, etc.

In short, the price-earnings ratio should only be used as a tool to compare different companies in the same industry with similar characteristics, not as a tool to compare companies across industries.

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