As a new stock market investor, one of the key financial metrics you should know about is the P/E ratio. Read this post to know more.

When evaluating investment opportunities in the stock market, it is crucial to master the key financial metrics. One metric commonly used by investors is the P/E (Price-to-Earnings) ratio. Also known as earnings multiple or price multiple, it offers valuable insights into a company's valuation and future prospects.

Let’s take a look at what is P/E ratio, how it is calculated, and more-

What is PE Ratio?

Price-to-Earnings ratios or P/E ratio is the ratio of a company's stock price to its Earnings Per Share (EPS). Essentially, P/E Ratio indicates how much the investors are willing to pay for every ₹1 in earnings generated by the company.

For instance, if the P/E ratio of a company is 10, investors are willing to pay ₹10 in its stock for ₹1 in earnings.

How to Calculate P/E Ratio?

The formula is as follows-

Let's say a company, ABC's current share price is ₹100, and its EPS is 10. So, ABC's P/E ratio is 10 (100/10).

What are the Different Types of P/E Ratios?

There are two types of Price-to-Earnings ratios commonly used by investors- Forward P/E and Trailing P/E. Here’s what they mean-

• Forward P/E Ratio

  Forward P/E is calculated by dividing the stock's current market price by the company’s EPS guidance or estimated earnings mentioned in the earnings report. As forward P/E considers the company’s estimated future earnings, it is also known as estimated P/E.

• Trailing P/E Ratio

  Trailing or Trailing Twelve Month (TTM) P/E is calculated by dividing the stock's current market price by the company's EPS for the past four quarters. Compared to forward P/E, TTM P/E is easier to calculate as it is not based on estimation but on the company's past earnings.

How to Interpret the P/E Ratio?

Every industry has a different P/E ratio. So, investors generally compare the P/E ratio of a company with other companies (mostly of similar size) from the same industry. Alternatively, investors can compare the current P/E ratio of the company with its historical P/E to determine if the company is undervalued or overvalued.

Here’s how investors analyse the P/E ratios-

• Higher P/E

  If the P/E of a company is high, it is considered that it is either on a growth trajectory or overvalued. A higher P/E ratio could also mean that the investors are confident about the company's growth potential and don’t mind paying a higher price to acquire its shares.

• Lower P/E

  Companies with a lower P/E are often considered undervalued. However, it could also mean that the investors are not confident about the company's future prospects, due to which its shares are trading at a lower price.

How Should Investors Use P/E Ratio for Investment?

There’s no ideal or good P/E ratio, as it can significantly vary between industries, market conditions, etc. As a result, when analysing the P/E ratio of a company, ensure that you also consider the performance of other companies from the same industry with similar growth trajectories and characteristics.

Also, avoid selecting stocks for investment solely based on the P/E ratio. Various other aspects deserve your attention, like-

● Industry average P/E
● Growth prospects of the company’s EPS
● Debt-to-equity ratio
● Company scale (Large, mid, or small-cap)
● Historical performance of the company, competitors, and overall industry
● The future potential of the industry

Using P/E Ratio for Stock Investments

The P/E ratio is one of the most commonly used financial metrics to choose stocks for investment. But while the P/E ratio can offer insights into whether a company is overvalued or undervalued, you should always use it in conjunction with other factors listed above.

Try to learn more about the fundamental and technical indicators used by investors to choose stocks for investments or consult with a SEBI-Registered Investment Advisor (RIA) for professional financial advisory services.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.