What Is P/E Ratio Meaning, How Is It Calculated and Its Impact on Investments

What is a P/E Ratio?

The price of an equity share on the stock market shows the current price that market participants are willing to pay to purchase shares of the company. However, the market price of a stock can be influenced by various factors such as market sentiment, economic outlook, current market liquidity, etc. This is where the P/E ratio or price to earnings ratio acts an important metric which tells whether or not the stock price accurately reflects the future earnings potential of the company with respect to its current stock price.

P/E ratio can be thus defined as the amount that market participants are willing to pay for each ₹1 of the earnings per share. If the general sentiment and predictions indicate a rise in future earnings, the market price of shares will increase and vice versa. Now if the stock price rises at a higher rate than the earnings, in that case, the P/E ratio of the stock will be high and it may be considered overvalued. Alternatively, if the market price of the stocks falls at a higher rate than the earnings, then the P/E ratio will be low.

While price to earnings ratio is typically calculated for individual stocks, it is also possible to calculate P/E ratio for stock indices and even for individual stocks held by equity mutual funds. However, due to constant changes in the price of stocks, the P/E ratio of both individual stocks and stock indices keeps on changing. Furthermore, when companies come out with their quarterly reports and earnings, the P/E ratio undergoes significant changes and fluctuations. There are three types of P/E ratios, namely Shriller P/E ratio, Forward Earnings, and TTM Earnings. So let’s see how P/E Ratio is calculated.

How to Calculate the P/E Ratio?

There are three ways of calculating the P/E ratios, let’s consider each one of them in detail:

Forward Earnings

As the name suggests, investors can compute this type of P/E ratio by using a company’s forward i.e. projected future earnings. It does not use the reported financials of the company, but it carries out a trend analysis of the financials to bring out how markets expect the company to perform in the coming years.

Trailing Twelve-Month Earnings 

Another way to compute the P/E ratio is by using the company’s earnings over the preceding 12 months. This type of P/E ratio is known as the Trailing Twelve Month (TTM) Earnings. One of the key advantages of using this method is that this P/E ratio is derived using reported and credible data, so it accurately indicates the past trend of the company’s performance. Due to the non-speculative nature of TTM Earnings, many large-cap and mid-cap companies as well as large cap mutual funds use this method to calculate the P/E ratio.

Shriller P/E Ratio

Under this method, one uses the average earnings of the company over some time. The Shriller ratio is also known as the cyclically adjusted price-earnings ratio. The current stock price is divided by the average earnings of the company over the past 10 years, adjusted for inflation.   

Example of P/E Ratio Calculation

Now that we are through with our discussion on the different ways of calculating the P/E ratio simplify our understanding of how P/E ratio is calculated by using an example. The basic formula to calculate P/E Ratio is this:

P/E Ratio = (Price per Share / Earnings per Share)

Suppose Company ABC is trading at the stock exchanges for ₹250. The annual earnings per share of the company is ₹10. Now using the P/E ratio formula (current stock price/ earnings per share) 250/10 = 25. The Price to Equity ratio comes out to 25. This tells us that if the earnings and stock price of the company remain constant, it would require the company around 25 years to have adequate profits and recover the share price.

Let’s consider a comparative analysis of the P/E ratio of two companies by considering the following information: