PE Ratio - What is Price Earnings Ratio?

Last week (Sep 7 to Sep 11) proved to be Nasdaq’s worst week since March, when the impact of Covid-19 outbreak caused a global stock market crash. Tech stocks listed on Nasdaq such as Amazon, Apple, Microsoft ended with steep losses. Among several other signs, experts said that price-to-earnings multiples — a common valuation measure nearly rose to dangerous levels associated with the dotcom bubble.

The dotcom bubble of the late 1990’s had witnessed a rally which inflated the worth of several technology companies. Huge losses were incurred by the investors later in 2001 and through 2002 when the bubble burst as the surge in value of internet stocks proved unsustainable. A similar surge in tech stocks, post the Covid-19 outbreak between March and September reminded market pundits of the dotcom bubble.

So, what is this price-to-earnings multiples or Price Earnings Ratio? How do experts analyse a stock’s P/E ratio to predict its future move?

The price to earnings ratio helps in understanding the growth potential of a company. It measures a company’s per-share price relative to its per-share earnings. High PE signals that investors are optimistic about the future earnings of the company and are willing to pay more. But it also means that the stock is overvalued.

One can understand P/E as a means used by analysts and investors to determine the relative value of a company’s share in an apples-to-apples comparison. For instance, if a stock’s PE ratio is 10, it simply means that investors are ready to pay 10x of the company’s earnings to buy it. Quite understandably, the companies that do not have earnings or are losing money, do not have a P/E ratio.

Trailing PE and Forward PE are the two types that you should know. To determine a stock’s trailing PE, earnings of the last 12 months are considered whereas in case of forward PE, earnings estimates over the next 12 months are taken into consideration.

Now let's go back to the example of US tech stocks in the beginning of the blog. According to Financial Times, Citigroup calculates that, once lower corporate tax rates are factored into valuations, the top 10 US tech companies are trading at a trailing 12-month price-to-earnings ratio of 75 times. The number is precisely in line with the turn of the century.

Growth vs Value Stocks

Companies that tend to have a high P/E ratio are understood to be growth stocks. Investors expect such stocks to do well in the future and hence are willing to pay more for them. Since these stocks may also be overvalued, they are associated with high risk. Companies that have low PE ratio are considered to be value stocks.

However, it must be noted that PE ratio should not be the sole criteria while making a trading decision. Market usually reacts to several factors at the same time. Prevailing interest rates, government policies and several other macro and microeconomic factors affect the stock price of a company.

Investing Based on P/E ratio

Investing is also about practice and experience. Experts advise against making trading decisions based only on P/E ratio. While P/E ratio is only the most tracked metric in trading, it could be misleading at times. Investing in shares must be done after careful study of the company. Since you are putting your hard-earned money in a company you should do your research on the background of the company, the nature of its operations, its promoters, the sustainability of the business, and future plans of the company.

Investors must also be aware of what the numbers in the financial statement signify. One does not need to be an equity analyst or an economist to understand the concepts involved in investing.

Any investor can learn to calculate PE ratio and EPS for instance.

EPS = Net Income- Preferred Dividends/No. of outstanding shares

PE ratio = share price/ EPS

Start investing by opening a Demat Account

Now that you have a basic understanding of concepts such as P/E ratio, you may wish to try your hand at investing. For this purpose, you require a demat account. There are several options available to open a free Demat account. A demat account helps investors hold various financial securities such shares, equity or debt in electronic form.

When you make an investment, all the physical security certificates such as bond certificates and share certificates and documents get converted into digital form and gets stored in your demat account which improves accessibility and keeps them secure. Demat accounts allow a number of facilities such as seamless transfer of shares. In India, Demat accounts are controlled by the Central Depository Service Limited and the National Securities Depository Limited.