Price Earnings Ratio (PE Ratio): Types and Investing Strategies

The P/E Ratio or Price to Earnings Ratio is one of the most important metrics in the ratio analysis of a security. It is the ratio of a company’s current share price relative to its earnings per share (EPS).

The price to earnings ratio helps in understanding the growth potential of a company. High P/E Ratio signals that investors are optimistic about the future earnings of the company and are willing to pay more. But, it also means that the stock is overvalued.

One can understand P/E as a means used by analysts and investors to determine the relative value of a company’s share in an apples-to-apples comparison. For instance, if a stock’s PE ratio is 10, it simply means that investors are ready to pay 10x of the company’s earnings to buy it. Quite understandably, the companies that do not have any earnings or are losing money, do not have a P/E ratio.

Types of P/E Ratios

There are two types of P/E ratios:

• Trailing P/E Ratio: Earnings of the last 12 months are considered to determine a stock’s trailing P/E. It provides a more accurate and objective view of a company’s performance.
• Forward P/E Ratio: In this case, earnings estimates over the next 12 months are taken into consideration. Investors use Forward P/E Ratio to assess how a company is expected to perform in the future and its estimated growth rate.

Growth vs Value Stocks

Companies that tend to have a high P/E ratio are known as growth stocks. Investors expect such stocks to do well in the future and hence are willing to pay more for them. Since these stocks may also be overvalued, they are associated with high risk. Companies that have a low P/E ratio are considered to be value stocks.

However, it is worth noting that the P/E ratio should not be the sole criteria while making a trading decision. The market usually reacts to several factors at the same time. Prevailing interest rates, government policies and several other macros and microeconomic factors affect the stock price of a company.

Investing Based on P/E ratio

Investing is also about practice and experience. Experts advise against making trading decisions based only on the P/E ratio. While it is only the most tracked metric in trading, it could be misleading at times. Investing in shares must be done after careful study of the company. It is important to do your research on the background of the company, the nature of its operations, its promoters, the sustainability of the business, and the plans of the company.

You can calculate P/E Ratio by dividing a company’s share price by its EPS (Earnings per Share). Now to calculate the EPS, you have to deduct all the company’s expenses, interest payments and tax from its revenue and divide this number by the total number of shares. The final number you get from this is the EPS. It determines the profit per share.

Start investing by opening a Demat Account

Now that you have a basic understanding of concepts such as the P/E ratio, you can begin investing. To start with, you require a Demat account. There are several options available to open a free Demat account. It helps investors hold various financial securities such as shares, equity or debt in electronic form.

When you invest, all the physical security certificates such as bond certificates and share certificates and documents get converted into digital form and are stored in your Demat account which improves accessibility and keeps them secure. Demat accounts allow several facilities such as seamless transfer of shares. In India, Demat accounts are controlled by the Central Depository Service Limited and the National Securities Depository Limited.