Can Investors Trust The P/E Ratio?

P/E Ratio

P/E ratio compares a company’s current stock price to its earnings per share, or EPS, which can be calculated based on historical data (for trailing PE) or forward-looking estimates (for forwarding PE). it is the ratio between the market price of the share and the earning per share. The ratio tells us how many times the market price of a share is vis-a-vis its earning.

PE ratio talks about the growth potential of a company. High PE simply means that investors are optimistic about the future earnings of the company and are willing to pay more. It also shows that the stock is overvalued. Trailing PE and Forward PE are the two types that you should be aware of. In the case of trailing PE, earnings of the last 12 months are considered whereas, in the case of forwarding PE, earnings estimate over the next 12 months are taken into consideration.

PE ratio is a commonly-used way to value a company and to determine what a company’s stock should be worth. It gives an indication of how many times one is paying for a company’s stock against the company’s earnings. PE ratios can be used to compare one company with other companies or against a company’s own historical PE ratios. Generally, a company with a high PE ratio is expensive as against a company with a low PE ratio, since with a high PE ratio one is paying a larger multiple than the company’s earnings. Higher PE ratios are often associated with ‘growth stocks’ , or companies that are growing faster than the average. Investors believe that the company’s earnings will be higher in the future. Usually, this is used to analyse whether a stock is undervalued, overvalued or trading at fair value.