Understanding the price-to-earnings ratio
The price-to-earnings (P/E) ratio indicates the unit amount an investor can expect to invest in a company in order to receive one unit of that company’s earnings. The P/E ratio is also known as the price multiple or the earnings multiple and is used by analysts and investors to understand the relative value of a company’s shares when comparing two investments.
The P/E ratio can be calculated by dividing the market value per share by earnings per share. In mutual funds, the P/E multiple of a scheme is arrived at by using a weighted average of underlying stocks. In other words, it is the average of the P/E ratio of all the stocks that make up the fund’s portfolio, in proportion to their allocation within the portfolio. A high portfolio P/E ratio would indicate that the scheme mostly holds stocks that are quoting a valuation premium. P/E ratio tells you the price per rupee of earning
To understand better let us take for example say, Company A is trading at a P/E of 20. So when you are buying the shares of Company A, you are paying the rate of Rs 20 for every rupee of earning for company A. Now if you have spent Rs 1,000 to purchase the share at the current market price you would get 1,000/20 = Rs 50 of the company’s earnings.
A high P/E ratio suggests the market participants are bullish on the stock and expect higher earnings going forward. However, sometimes it could also mean a stock is overpriced. Whereas a lower P/E ratio can be interpreted as an undervalued stock or the investors aren’t too bullish on the company’s future. Having said that this may not always hold true as P/E ratio varies from industry-to-industry.There are two common types of P/E ratio, the forward P/E and the trailing P/E. A trailing P/E is the valuation based on the previous financial year of actual earnings, whereas a forward P/E is based on the estimated earnings for the next 12 months. P/E ratio can indicate or be seen as a benchmark on whether or not a stock is worth the buy.