When investing in the stock market, numerous shares are available, each selling at a different rate. Many may seem promising investments, but is there an easy way to compare them? How do you decide which shares may make better investments? PE ratio is an easy-to-calculate metric that helps you identify the best investment options. Read this to learn more about it.
What is a PE ratio?
PE Ratio is short for Price to Earnings Ratio. With this ratio, you assess the value of the share price compared to its earnings per share (EPS). In other words, it is the market price of the share divided by the EPS.
So if the shares of XYZ Ltd are selling in the market for ₹1,000, and the EPS is ₹100, the PE ratio for XYZ Ltd is 1,000/100. That is 10.
All clear so far? Now, suppose there is another company, ABC Ltd, whose shares are selling for ₹1,000, but the EPS is ₹50. ABC Ltd’s PE ratio will be 1,000/50 =20. Though the market price of both these shares is the same (₹1,000), the PE ratios are different.
Which do you suppose would be a better investment? XYZ Ltd, right? Because you will be receiving double the returns of ABC Ltd with it. That’s why the PE is lower.
Drawing on this, it must be clear that the lower the PE, the better the investment. This ratio helps determine whether a company’s share is overvalued or undervalued.
The PE ratio formula
The formula for calculating this metric is simple.
PE ratio = Market price per share/EPS
In this formula, the meaning of the terms involved is as follows:
The market price per share is the current market price at which a single share of the company can be bought. This price includes brokerage charges and other incidental charges.
The EPS is the portion of the company’s profit that will be paid out to each share of that company.
How to calculate the PE ratio
As discussed, this metric is calculated by dividing the market price per share by the company’s EPS. That is, Market price per share/EPS
Example: If a company’s share is trading at ₹500 per share, and its EPS is ₹25, the
PE is 500/25 = 20.
This can be interpreted as the market’s willingness to pay ₹20 for each ₹1 that the company generates as income.
Conclusion
PE is an excellent way to compare and determine which investment would maximize your returns on investment. When the same amount of investment can generate greater returns, your investment becomes more profitable. It can, therefore, be stated that this ratio measures the current market expectation of the company’s future performance.
To learn more about it, click here.
FAQs
1. What is a good PE ratio?
This ratio is basically the current market value per share of a company divided by its EPS. So, the lower it is, the better that company’s share is for investment purposes. It shows that you are receiving more returns on your investment.
2. Is a high PE ratio good?
No. A high PE ratio shows that the company’s share is overpriced. The same amount of money, if invested in a company with a lower PE ratio, will fetch you greater returns.
3. What does the PE ratio indicate?
This ratio indicates whether, currently, the share is overpriced or underpriced. If the ratio is high, the returns on the investment are lower than when invested in shares with a lower ratio because the same invested amount generates lower returns to the investor.
