# Price to Earning Ratio (PE) | Earning Per Share (EPS) | Stock Market Terms 4

Hello friends. In this blog, we discuss various financial topics. That is why we have launched the ‘Stock Market Terms‘ series. This is the fourth post of that series. The topic of our discussion in today’s post is the Price to Earnings Ratio. In the previous post, we discussed “Market Capitalization“. Click here to read that article because if you have a clear idea about market capitalization, it will be easy for you to understand Enterprise Value.

Contents

## What is PE Ratio

PE Ratio is the comparison between the current market price of the Stock and the amount company earns for each share of the company. Another way to say this is how much premium an investor has to pay to buy a unit of the share. This might seem complicated. Well, do not worry. We will understand this with an example. However, to understand PE Ratio, we have to get a clear idea of Earning Per Share or EPS.

## What is Earning Per Share (EPS)

Earning Per Share (EPS) is the amount that a company earns for each share of the company. EPS can be found by dividing the total earnings of the Company by the Total Number of Shares of the Company. Hence,

EPS = Total Earning of the Company/ Total Number of Shares of the Company

Let’s understand this with an example. At the end of Sep’21 quarter, the total earning of ITC is 15,042.81 Cr. and the total number of Shares of ITC is 1232.27 Cr. Hence, the EPS of ITC in this case is = (15,042.81/1232.27) = 12.01. This means, for each share, the company ITC is earning 12.01 Rs. As we have understood EPS, now we will learn P/E Ratio with an example.

## How to calculate P/E Ratio

The formula to calculate P/E Ratio is as below,

P/E Ratio = (Current Market Price of the Stock/Current EPS of the Stock)

As of 15.02.22, the current market price of ITC is 223 and the current EPS is 12.01. Hence, the P/E Ratio of ITC is = (223/12.01) = 18.56. This means investors are ready to pay 18.56 times the present earnings (in the case of one stock) of the company to buy a unit of the stock. Why so? We will discuss this in the next paragraph.

## What P/E tell?

Generally, a higher P/E of any stock indicates that it is overvalued, whereas a lower P/E indicates the stock is undervalued. However, this is not a fixed rule. For high-growth companies, the P/E which seems higher right now may become lower in upcoming years in today’s comparison, as the CMP of the stock will grow.

## Types of P/E

There are two types of P.E. ratio. One is Trailing and the other is Forwarding. In trailing P.E., we calculate any company’s P.E. in terms of its past performance, while in forwarding P.E. we try to assume the company’s projected P.E. by analyzing its current performance.

## How to use PE Ratio

PE Ratio is a valuation tool and probably the most widely used ratio in the financial world. While using PE Ratio, the following things should be considered,

### Historical P.E.

Historical P.E. of stock provides important insights. If a fundamentally strong stock is trading below its historical P.E. this indicates that the stock is undervalued.

### Peer’s P.E.

P.E. of any fundamentally strong stock’s peer is also very important. If a stock is trading below its industrial peers, it may be a good investment

### Industrial P.E.

The average P.E. of the industry to which the stock belongs is very important. If any fundamentally strong stock is trading below its industrial P.E., it may be a good investment as right now the market is not ready to give it a higher premium. However, as it is a fundamentally strong stock, in the future its P.E. will rise as well as Price. An early entry in this kind of stock can generate huge wealth.

### Index P.E.

The P/E of index i.e. Nifty or Sensex gives a holistic idea about the market sentiment. Hence, at the time of investing while considering P/E of a stock, one must check the index P.E.

### PEG Ratio

PEG Ratio is the comparison between the Price to Earning of a company and Earning growth rate of a company. While considering the P/E Ratio of a company, its PEG Ratio should also be checked and this must go hand to hand with PE Ratio.

### Sales Growth

The growth of P.E. should be at par with the sales growth of the company. If the company’s sales growth and its P.E.s growth are not going hand in hand, it is a clear indication of something doubtful.

For companies in Real Estate, Mining, and Mineral sectors, the P/E ratio tells too little about the company.

## Should you buy stocks of higher P.E.?

A company that is growing at a very fast rate demands higher P.E. as its future projections are very good, and investors have no problem buying these stocks at higher P.E. Many IT companies like Infosys, and Wipro is always traded at a very high P.E. This is because investors are sure about these company’s future growth and they are ready to pay the premium.

## P.E. Ratio may tamper

Though the PE ratio is one of the most important financial ratios, it may be tampered with easily. Many companies use this trick to attract investments. Let us see, how they can do it.

Suppose, in the year 2021, Company A’s current market price is Rs. 10, earnings are Rs. 100 & its total share is 20. Hence, its EPS is (100/20) = Rs. 5 & PE is (10/5) = Rs. 2.

On many occasions, companies receive huge payments from things like rent, land sales, etc. They show this in their earnings. However, these are not coming from its main operation and these are basically one-time payments. This thing can easily tamper with the P/E ratio of a company. Let’s understand this with the above-mentioned example.

Now, suppose, in the year 2022, Company A’s current market price is Rs. 12, earning is Rs. 130. This time the extra Rs. 30 it has earned from land selling; & its total share is 20. Hence, its EPS is (130/20) = Rs. 6.5 & PE is (12/6.5) = Rs. 1.84.

In this case, the PE of company A for the year, 2022 may seem to be lesser than 2021. However, its PE has decreased only due to the one-time payment is received. Companies are not going to get that kind of payment every year. Hence, if an investor entered into the stock only by watching lower P.E., he may get trapped.

## Conclusion

While considering the P.E. Ratio of a stock, one should check all the other parameters before investing, viz. its sales growth, PEG Ratio, industry P.E., and also try to find the reason behind the higher/lower P.E. of the stock.