Analysing stocks and schemes is the key to sailing through market volatility and succeeding in your investment. Whether you invest in stocks or mutual fund schemes, it’s good to know the company’s performance and prospects through different metrics. P/E (price-to-earnings) ratio is one of the more important metrics to consider for a stock’s valuation. Let us understand more about the P/E ratio and how it determines the value of a stock.
What is P/E Ratio?
P/E ratio stands for the price-to-earnings ratio. It is a metric used by investors and stock analysts across the globe to determine the valuation of stocks and how favourable it is to invest in them. The P/E ratio is the ratio of the current market price to the earnings per share in a specific period. Analysts and investors may use different periods to determine the P/E ratio. However, a duration of one year is considered commonly by most analysts.
Examining the P/E ratio, investors and stock analysts can estimate whether a stock is overvalued or undervalued. So, whether you invest in equity mutual fund schemes or stocks, knowing P/E ratio beforehand can prove particularly helpful.
How to calculate the P/E ratio?
The P/E ratio compares the current market value of a share to earnings per share. We need to divide a share's current market value by the earnings per share in a specific period to determine the price-to-earnings ratio. Mathematically, it is represented as:
Profit to Earning Ratio (PE Ratio) = (Current Share Price) / (Earnings per Share)
Let us assume that you are planning to invest in the shares of ABC company, whose current stock price is ₹1000. Earnings per share for this stock is ₹50. Hence, the P/E ratio for stocks of ABC company can be calculated as:
P/E ratio = 1000 / 50 = 20
What are the types of PE ratios?
Investors primarily consider two types of PE ratios in their analysis: the Forward PE ratio and the Trailing PE ratio. Both depend on the nature and type of earning.1. Forward P/E ratio
So while the traditional P/E ratio is calculated using historical earnings, the forward P/E ratio is calculated using estimated or projected earnings for the future period.
Simply put, the forward P/E ratio is calculated based on the current market price of the share divided by the projected earnings per share (EPS) over the coming 12 months. Determining the forward P/E ratio involves sales forecasting, P&L (Profit and loss), EPS, and margins. So, analysts need prior knowledge and expertise to calculate the forward PE ratio. The future sales and earnings and the P/E ratio are estimated based on the guidance provided by the company management and stock analysis.
Forward P/E Ratio =
Current Stock Price / Estimated Earnings Per Share (EPS) for the Next 12 Months
Let’s break down the components of this formula:
Current Stock Price: This is the market price of the company's stock
Estimated Earnings Per Share (EPS) for the Next 12 Months: This represents the anticipated earnings of the company for the upcoming year.
Analysts, investors, and the company itself may provide these earnings estimates. The EPS is a measure of a company's profitability, calculated as:
EPS = (Net Income - Dividends on Preferred Stock) / Average Outstanding Shares
It's important to note that forward P/E ratios are based on estimates, which may not always be accurate. Market conditions, company performance, and economic factors can change, making the actual future earnings different from the estimates.2. Trailing PE ratio
The trailing P/E ratio is calculated based on the current share price divided by the earnings per share (EPS) of the last 12 months. These PE ratios are easy to determine since most companies declare their financial data at the end of every quarter.
The forward P/E ratio is relatively more relevant since it forecasts the future price fluctuations of a stock. However, the trailing PE ratio can describe whether the prices of stocks are too high or low compared to their past performances.
What is the significance of the PE ratio?
P/E ratio helps in determining the valuation of a stock. High P/E ratio usually indicates that the stock is overvalued. In contrast, a low P/E ratio typically denotes that the stock is undervalued.
But how do you know if the stock is overvalued or undervalued? Comparing the P/E ratios of the competitors from the same sectors/categories can help do so. An undervalued stock has better prospects of future growth, while overvalued stocks tend to perform poorly, as they are already overpriced to derive considerable returns.
The bottom line
Now you know the aspects of the PE ratio and its significance in mutual fund investments. An informed decision can help you cope with market volatility and might help with earning better returns.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.