Understanding key financial metrics like the Price-to-Earnings (PE) ratio is crucial for making informed decisions when investing in the Indian share market. This blog post explains the PE ratio, how to interpret it, the different types of PE ratios, and, most importantly, how investors can utilise it to make better investment choices in India. Look at this blog to learn how to use PE meaning in the share market to make better investment decisions.
What is the PE (Price-to-Earnings) Ratio?
The PE ratio is a popular financial metric used globally by investors to gauge whether a company’s shares are overvalued, undervalued, or reasonably priced. It is among the investment community’s most widely tracked and analysed valuation multiples.
How to Interpret PE Ratio?
To correctly interpret the PE ratio, you need to know the different types of PE ratios:
1. High PE Ratio
A high price-to-earnings ratio relative to industry peers often signals that investors expect high earnings growth potential in the future, which justifies the premium valuation. However, an exceptionally high PE ratio suggests that the company’s shares are potentially overpriced and overvalued by the market, significantly if growth expectations decline. Investors should dig deeper to ascertain whether underlying fundamentals support the high valuation multiples.
2. Low PE Ratio
Conversely, a low PE ratio suggests the company’s shares may be available at a bargain compared to the underlying earnings per share. However, an extremely low ratio versus industry averages could also indicate financial problems, poor profitability, and a bearish outlook for the company’s future earnings potential. Investors need to assess if the low PE ratio represents an investment opportunity or if it reflects dim growth prospects ahead.
Types of PE (Price- to Earning) Ratios
There are two types of PE ratios:
1. Trailing PE Ratio
The trailing price-to-earnings ratio is based on the company’s past earnings, usually from the preceding 12 months. This gives investors a reliable measure of valuation based on historical data.
2. Forward PE Ratio
In contrast, the forward PE ratio is based on estimated future earnings, often sourced from analyst forecasts for the next 12 months. This ratio aims to provide a predictive measure of upcoming financial performance.
Using PE Ratio for Investment Decisions
PE ratio can be used to make better investment decisions:
1. Compare PE with the Industry Average
Investors can gauge whether the share is undervalued or overvalued by comparing a company’s current PE ratio relative to the industry average and competitors. This signals if the market sentiment is factoring in expected outperformance or underperformance in earnings growth compared to peers.
2. Analyse Historical PE Trends
Studying the historical PE ratio trends reveals how much investors have traditionally been willing to pay for the company’s earnings over time. For example, a declining PE ratio over the long term could indicate that the stock may be undervalued relative to historical norms.
3. Use PE Ratio with Other Metrics
Rather than using the PE ratio in isolation, combining it with other parameters such as the price-to-book ratio, return on equity, and debt levels leads to a more holistic view. This aggregated analysis provides better context than just observing the PE ratio itself.
4. Factor in Market Conditions
Investors should also consider prevailing market conditions while analysing PE ratios. The ratio tends to expand during bull market phases when sentiment is buoyant, while bear phases typically see PE contraction due to negative sentiment.
Limitations of PE Ratio
The PE ratio comes along with a lot of limitations, such as:
1. Ignores Debt Situation and Expense
The price-to-earnings ratio does not factor in the debt situation and interest expenses on that debt. A company can have significant borrowings and high-interest costs that hurt profitability but still show a low PE ratio. Hence, focusing solely on PE would ignore potential risks from leveraged balance sheets.
2. Earnings Per Share Can Be Manipulated
Creative accounting practices can manipulate a company’s reported earnings per share. Non-cash expenses, one-time adjustments, deferred expenditures, etc., can alter bottom-line figures, impacting the reliability of the PE ratio. Therefore, investors should review earning quality before taking the earnings per share metric at face value when evaluating PE ratios.
3. Not Useful for Loss-Making Startups and Companies
As a valuation multiple based on earnings, the price-to-earnings ratio cannot effectively be used for loss-making, early-stage startups with negative earnings. Since there are no profits to compare to share prices, other relative valuation methods must be deployed to assess upside potential.
Conclusion
The price-to-earnings ratio helps determine whether a stock price aligns with a company’s underlying earnings. Investors can compare it with industry averages and historical levels and use other metrics to ascertain whether a share is undervalued or overpriced.
