While valuing an individual share or stockmarket indicators such as Sensex or Nifty, financial analysts give due weightage to the price-earnings ratio (P/E ratio). This ratio is also known as earnings-multiple ratio.
This ratio is computed by considering the current price of a share divided by its earnings per share (EPS). For instance, let us take cement company ABC whose most recent price is R1,310 and EPS is R21. The price-earnings ratio will then be R1,310/21 = 62 times. It means that one rupee earned by this cement company is perceived by the market as equal to R62. It reflects the price currently being paid by the market for each rupee of reported EPS. In other words, the P/E ratio measures investors expectations and the market appraisal of the performance of the firm.
Variants of P/E ratio
Trailing P/E: When the P/E ratio is computed by considering the EPS of the last four quarters, it is called trailing P/E. The drawback of this method is that it considers only the past data and not future earnings or growth potential.
Forward P/E: Under this method, the P/E is computed by considering the EPS of the projected next four quarters. This is also known as leading P/E. This method is better than trailing P/E as it considers the firms growth potential.
Significance of P/E ratio
The P/E ratio is directly linked with the fundamentals of a company. The ratio consider the past performance as well as the future growth of the firm. To a greater extent, this ratio also considers the debt capacity of the firm. For instance, when a firm has higher amount of debt in its balance sheet, it affects the EPS and share price in many ways. Though debt provides firms the benefits of leverage and tax shield, it also enhances the probability of bankruptcy and risk to the equity shareholders. Generally, firms with higher amount of debt, such as heavy and capital intensive industries, tend to have a lower P/E ratios than less capital intensive industries. Firms exposed to economic cycles have a lower P/E ratios than those not affected by them. For instance, firms in the FMCG sector generally have higher P/E than those in the iron and steel segment.
P/E ratio & valuation of shares
Suppose you are planning to buy ABC companys share. Compare the P/E ratio of this company with that of similar companies in terms of size. Having identified comparable companies, you have to compute the P/E ratios of these firms, after adjusting for the earnings, and obtain the median, which is also known as the industry median.
Now, compare ABCs P/E with that of the industry median. If ABC has a P/E higher than the industry average, this means that market have high expectations from the firm in the near future and, often, this could be stated that the company is over-valued.
If ABC has a P/E lower than that of the industry average, it need not necessarily mean that the company is under-valued. The market might believe that company is not going to perform well in the near future. So, whether a share is cheap, high, or fairly priced, can be determined by each investor only after duly considering other quantitative and qualitative factors of the company.
Though P/E ratio computations looks simple, there are difficulties in adjusting the earnings to make it comparable across peer group. But, if done correctly, it can provide valuable inputs for taking the right investment decisions.
Source :
The finacial express
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