Price-to-Earnings Ratio is one of the easiest financial ratios and most followed by investors across the world. Here is a simple understanding, importance and drawbacks. 

FORMULA AND CALCULATION:

P/E Ratio = Current Market Price/ Earnings per Share

Where, Earning Per Share = Net Profit of the Company/ Outstanding Number of Shares

Suppose, a Company Earns 160 Million as a Net Profit having 4 Million shares and Current Market Price is 600.

Calculating from the above formula EPS is 40 and P/E ratio is 15. With the fluctuation of price, P/E Ratio also changes.

WHAT SHOULD BE THE IDEAL P/E RATIO?

There is no as such benchmark satisfying everyone’s conceptions and most suitable P/E Ratio for any company. Practically stock P/E Ratios varies from 5 to 100 according to Industry type, Growth Prospectus, Competition etc.

Sector P/E is also something which is important to look at. FMCG sector stocks are trading at P/E Ratio above 65. So, if someone wants to compare P/E Ratio of FMCG Company, it should be with other FMCG Company or Sector P/E and not with any other Company, say, Power Sector Companies which are trading below 15 P/E Ratio.

There is also a measurement of Index P/E Ratio. Historically speaking, 20-30 is a well defined range of Index P/E by Market itself. Whenever Index P/E goes below 20 Value investors buy and whenever it goes around 30 they sell.

IS HIGHER PE IS ALWAYS BAD AND LOWER PE GOOD?

Stock Market is a future discounting machinery, where Companies are traded according to future growth opportunities and de-growth possibilities. There are also other financial ratios, such as ROE, ROCE, Price/Book Ratio, which affects the Market Price of a Stock and therefore P/E Ratio.

Any Company with higher ROE and ROCE compared to it’s Peers will command premium against peers. Therefore, naturally, their P/E will also be higher. Also, promoter pedigree affects P/E Ratio.

Let’s understand with the example of Insurance Companies listed on Indian Stock Exchanges:

If you are holding any such stock, higher P/E should not be the sole reason for profit booking. Sometimes, stocks with higher P/E may be trading as a future discounting machinery, or higher ROE and ROCE, so purely looking at P/E and not investing just because it is trading at a premium to the peers is not good. This may sometimes lead to missed opportunity.

I am also not suggesting chasing high P/E stocks, because sometimes one bad quarterly result may lead to severe downfall.

Do not neglect P/E Ratio, but also don’t take decisions solely looking at it.