Price to Earnings Ratio (P/E Ratio), simply put, is a tool for investors and analysts to determine the relative value of a company’s shares. P/E Ratio is a ratio to value a company’s shares by measuring its current price to its earnings per share (EPS).
A hypothetical company called ABC Private Limited (ABCPL) has its share priced at Rs. 100. The company’s profit for the last fiscal year was Rs. 10,00,000, and the number of shares outstanding (the shares which may be traded by investors) were 1,00,000. This amounts to an EPS of Rs. 10,00,000/1,00,000 = Rs. 10.
Therefore, the P/E Ratio for ABCPL is Rs. 100/10 = 10
How does P/E Ratio help investors?
An investor, while deciding to buy a share, classifies the said share as undervalued, correctly priced, or overvalued. A higher P/E Ratio would generally signify that the share is overpriced, and likewise, a lower ratio P/E Ratio would signify that the share is underpriced. However, a higher P/E Ratio would also highlight the fact that the investors see great value in buying the stock, which may be because they expect the company to do well in the future, while a lower P/E Ratio would point to the opposite. So what an investor generally looks forward to is to buy a share at its correct price or at an ideal P/E Ratio.
Ideal P/E Ratio
The definition of what makes for an ideal P/E Ratio is a long-standing debate . However, a good way to look at it is to focus on the industry in which the company is operating at the time. Some industries tend to have a high P/E Ratio, while for others it is low. Other practices usually followed to determine the ideal P/E Ratio includes basing it on an index. That is, the average P/E Ratio of the top 30 or 50 companies is often considered ideal and used to determine whether a share is overpriced or underpriced.
What does a P/E Ratio of 10 mean?]
A P/E Ratio of 10 would mean that if hypothetically an investor owns all the company’s shares, it would take the said investor 10 years to redeem the initial investment.
It should be noted that P/E Ratio is just one of the tools to measure share value, and an investor should ideally apply his/her intellect and judgment before investing.