PRICE TO EARNING RATIO

By: Surbhi Agarwal

Pallavi Tikoo
 What is P/E ratio
• The P/E ratio (price-to-earnings ratio) of a stock (also called its
"P/E", or simply "multiple") is a measure of the price paid for
a share relative to the annual net income or profit earned by the
firm per share.
•  It is a financial ratio used for valuation: a higher P/E ratio means
that investors are paying more for each unit of net income, so
the stock is more expensive compared to one with lower P/E
ratio.
• The P/E ratio has units of years, which can be interpreted as
"number of years of earnings to pay back purchase price",
ignoring the time value of money. In other words, P/E ratio
shows current investor demand for a company share.
 Contd……..
• The reciprocal of the PE ratio is known as the earnings yield. The
earnings yield is an estimate of expected return to be earned from
holding the stock.

P/E Ratio = Price per share

Annual earnings per share

• The price per share in the numerator is the market price of a single

share of the stock. The earnings per share in the denominator depends
on the type of P/E:
• "Trailing P/E" : Earnings per share is the net income of the company for
the most recent 12 month period, divided by number of shares
outstanding. Monthly earning data for individual companies are not
available, so the previous four quarterly earnings reports are used
and earnings per share is updated quarterly.
• "Trailing P/E from continued operations": Instead of net
income, uses operating earnings which exclude earnings
from discontinued operations, extraordinary items (e.g.
one-off windfalls and writedowns), or accounting changes.
Note, longer-term P/E data such as Schiller's uses net
earnings.
• "Forward P/E”: Instead of net income, uses estimated net
earnings over next 12 months. Estimates are typically
derived as the mean of a select group of analysts (note,
selection criteria is rarely cited). In times of rapid economic
dislocation, such estimates become less relevant as "the
situation changes" (e.g. new economic data is published
and/or the basis of their forecasts become obsolete) more
quickly than analysts adjust their forecasts.
 Uses of P/E Ratio
• The P/E is more than a measure of a company's past
performance. It also takes into account market expectations
for a company's growth. Remember, stock prices reflect what
investors think a company will be worth. As a result, a better
way of interpreting the P/E ratio is as a reflection of the
market's optimism concerning a company's growth prospects. 
• If a company has a P/E higher than the market or industry
average, this means that the market is expecting big things
over the next few months or years. A company with a high P/E
ratio will eventually have to live up to the high rating by
substantially increasing its earnings, or the stock price will
need to drop. 
• It's difficult to determine whether a particular P/E is high or low without
taking into account two main factors: 

1. Company growth rates - How fast has the company been growing in the
past, and are these rates expected to increase, or at least continue, in the
future? Something isn't right if a company has only grown at 5% in the past
and still has a stratospheric P/E. If projected growth rates don't justify the
P/E, then a stock might be overpriced. In this situation, all you have to do is
calculate the P/E using projected EPS. 

2. Industry - It is only useful to compare companies if they are in the same

industry. For example, utilities typically have low multiples because they
are low growth, stable industries. In contrast, the technology industry is
characterized by phenomenal growth rates and constant change.
Comparing a tech company to a utility is useless. You should only compare
high-growth companies to others in the same industry, or to the industry
average.
 Problems with P/E Ratio
• Till now we have studied about the P/E ratio and how it is calculated.
But P/E analysis is only valid in certain circumstances and it has its
pitfalls. Some factors that can undermine the usefulness of the P/E
ratio include: 
• Accounting : Earnings is an accounting figure that includes non-cash
items. Furthermore, the guidelines for determining earnings are
governed by accounting rules (Generally Accepted Accounting
Principles (GAAP)) that change over time and are different in each
country. To complicate matters, EPS can be twisted, prodded and
squeezed into various numbers depending on how you do the books.
• Inflation: In times of high inflation, inventory and depreciation costs
tend to be understated because the replacement costs of goods and
equipment rise with the general level of prices.
• Thus, P/E ratios tend to be lower during times of high
inflation because the market sees earnings as artificially
distorted upwards. As with all ratios, it's more valuable to
look at the P/E over time in order to determine the trend.
Inflation makes this difficult, as past information is less
useful today. 
• Many Interpretations: A low P/E ratio does not necessarily
mean that a company is undervalued. Rather, it could mean
that the market believes the company is headed for trouble
in the near future. Stocks that go down usually do so for a
reason. It may be that a company has warned that earnings
will come in lower than expected. This wouldn't be reflected
in a trailing P/E ratio until earnings are actually released,
during which time the company might look undervalued. 
 Conclusion
• While concluding we can say that it can be useful to compare the
P/E of one company to another in the same industry, to the market
in general, or to the company's own historical P/E ratios. 
Some points to remember:
• The P/E ratio is the current stock price of a company divided by
its earnings per share (EPS).
• Variations exist using trailing EPS, forward EPS, or an average of the
two.
• Historically, the average P/E ratio in the market has been around
15-25.
• Theoretically, a stock's P/E tells us how much investors are willing
to pay per dollar of earnings.
• A better interpretation of the P/E ratio is to see it as a
reflection of the market's optimism concerning a firm's growth
prospects.
• The P/E ratio is a much better indicator of a stock's value than
the market price alone.
• In general, it's difficult to say whether a particular P/E is high
or low without taking into account growth rates and the
industry.
• Changes in accounting rules as well as differing EPS
calculations can make analysis difficult.
• P/E ratios are generally lower during times of high inflation.
• There are many explanations as to why a company has a low
P/E.
• Don't base any buy or sell decision on the multiple alone.