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A Mystery Called 'P/E Ratio' (Price Earnings Ratio)

BY: Vivek SHARMA | Category: Finance | Submitted: 2010-11-28 08:44:31
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Article Summary: "This article talks about P/E ratio and its interpretation. P/E ratio along with EPS is used for finding out the value of market price of stocks..."


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The P/E ratio or Price/Earning ratio is the most talked about ratio in the valuation of equity shares. P/E ratio along with EPS is used for finding out the value of market price of shares. While EPS is an accounting derived value, P/E ratio is calculated and arrived at using a different method.

EPS of an equity share is

Profit after tax - Preference dividend, if any
= ------------------------------------------------------------------
No. of Equity shares


AND

P/E ratio is calculated using the following formula:

Market price of equity shares
= -------------------------------------------------------
EPS of share


P/E ratio in general terms can be explained as the number of years required for the earnings of a share to pay back the market price. Let us understand this with an example. If the EPS of a company's share is Rs. 10 and its market price is Rs. 100, this means that the P/E ratio is Rs. 10. In this example, it is clear that it will take EPS of Rs. 10 for 10 years to generate Rs. 100, which is the current market price of the share.

Stocks with higher forecast of earnings growth in the years to come will usually have a higher P/E, and those expected to have lower earnings growth will in most cases have a lower P/E. Why does this happen? This happens because the stocks having higher earning growth are likely to grow fast in the future and this earning growth results in market pricing a stock at a higher value. It is important to note that the growth of a company is a function of earnings it generates and how is the earnings deployed for growth in future. A high earning coupled with efficient deployment of the same has multiplier effect for company's growth.

There is a joke which is often heard in the market related to P/E ratio. This talks about the fact that P/E ratio indicates how long the company is going to survive. This means that if a company has P/E ratio of 20, it will remain in existence for atleast 20 years so that it is able to generate earnings to cover its current price. P/E ratio cannot be viewed or interpreted in isolation. It is always better to do peer group comparison in case of P/E ratio. This means that industry specific comparison for P/E ratio is always better. Even within industry, one should look at different size and scale of operations. You cannot compare P/E of Dena Bank to SBI.

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Comments on this article: (2 comments so far)

Comment Comment By Comment Date
Hi sir, your article is helful in getting information regarding financial aspects.thanks for the good job & try to give the explanation in simple way,its seems quite difficult to understand for beginers.. viswa 2011-01-26 06:40:38 561
very good narration for understanding to beginners . parimal 2011-09-19 04:17:09 934

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