The Price-Earnings Ratio (also known as P/E ratio) is widely used by investors and analysts for valuing companies in an attempt to gauge whether they are overvalued or undervalued compared to other companies in the same sector or a benchmark like the stock index (NIFTY50 etc) 

P/E Ratio = Market price per share/Earnings per share

(Earnings per share = Net Income/Total number of outstanding shares) 

How to interpret it? 

The P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E could indicate that a stock is possibly overvalued and its price is high relative to earnings while a low P/E might indicate a low price relative to earnings. 

It is important to note that companies which have high growth potential have higher P/E ratio (think technology companies). So, a higher P/E ratio can also mean that investors are willing to pay a higher share price today because of growth expectations in the future. 

CALCULATING THE P/E RATIO

 Earnings per share (EPS) is the portion of a company’s net income that would be earned per share if all the profits were paid out to its shareholders. EPS is used typically by analysts and traders to establish the financial strength of a company.

Types of P/E Ratio

1) Current P/E – based on financial year

2) Trailing P/E – based on last 4 quarterly results

3) Forward P/E – Based on projected EPS and current market price

ANALYZING THE P/E Ratio :

Generally, an industry group will benefit during an upturn of the business cycle so many professional investors will concentrate on such a group. Since the P/E is a measure of expected earnings, as economies mature, inflation tends to rise. As a result, the Federal Reserve increases interest rates to slow the economy and tame inflation to prevent a rapid rise in prices. 

On the other hand, toward the end of an economic recession, interest rates will typically be low, and banks typically earn less revenue. However, consumer cyclical stocks usually have higher earnings because consumers may be more willing to purchase on credit when rates are low.

LIMITATIONS OF THE P/E RATIO 

The most difficult task is determining an appropriate earnings number to calculate this ratio efficiently. Investors must determine how to define earnings and the factors that impact earnings.

The biggest limitation to the P/E ratio is that it tells investors little about the company’s EPS growth prospects since earnings growth is not included in this ratio. To address this limitation,  investors turn to another ratio called the PEG ratio. The PEG ratio measures the relationship between the price/earnings ratio and earnings growth to provide investors with a more complete story than the P/E alone. 

P/E ratios of some well known companies

(source: moneycontrol )

                                        March 2021     March 2020

Reliance Industries           26.23           17.49

Hindustan Unilever           71.45            73.74

TCS                                     36.65            21.19

ITC                                      20.42            13.77