What is the PE Ratio in the Share Market?

The PE (price-to-earnings) ratio shows how much people are willing to pay for ₹1 of a company’s earnings. It compares a company’s share price to its earnings per share (EPS). Investors use it to check if a stock is overvalued or undervalued.

Let’s take an example of Company A. Its current share price is ₹500, and its earnings per share (EPS) are ₹25.

We calculate the PE ratio as:

PE Ratio = Share Price ÷ Earnings Per Share

PE Ratio = ₹500 ÷ ₹25 = 20

This means investors are ready to pay ₹20 for every ₹1 the company earns.
 

Now that we have the PE ratios, we can compare them to understand what they might tell us about each company’s stock.

A higher PE ratio may indicate that a stock is expensive or expected to grow rapidly, while a lower PE might suggest the stock is relatively inexpensive or not growing.

Why the P/E Ratio Matters to Investors?

Investors often use the P/E (Price-to-Earnings) ratio to check if a stock is fairly priced. It shows how much people are ready to pay now for every ₹1 the company earns.

How to Use the P/E Ratio?
 

• Compare with Other Companies: Investors compare a company’s P/E with others in the same industry.
   
• Check the Overall Market: Investors use the P/E of big indices like the S&P 500 to judge if the overall market is expensive or cheap. However, in India, it makes more sense to use the Nifty 50, which tracks 50 of the top Indian companies and reflects the health of the country's stock market.
   
• Look at Long-Term Averages: Analysts use P/E10 or P/E30, which average earnings over 10 or 30 years, to see long-term trends.

The S&P 500’s P/E ratio has changed a lot over time.
 

A very high P/E (like in 2009) may mean profits are low or prices are too high. A low P/E (like in 1949) could mean the market is undervalued. So, the P/E ratio helps investors make smart decisions.

How to Calculate the P/E Ratio?

The Price-to-Earnings (P/E) ratio shows how much investors are willing to pay for ₹1 of a company's earnings. It uses the following simple formula:

Read More – What is ROE in the Stock Market? Meaning, Formula

P/E Ratio Formula=Market Price per Share/Earnings per Share (EPS)

• Market Price per Share is the current trading price of one share.
• EPS (Earnings Per Share) is the company’s net profit divided by the total number of shares.
• EPS is shown as:
  • TTM (Trailing Twelve Months): Earnings of the past 12 months.
  • Forward EPS: Predicted future earnings (company’s guidance).
     

P/E Ratio Calculation
 

• Trailing P/E = ₹500 ÷ ₹25 = 20
• Forward P/E = ₹500 ÷ ₹30 = 16.67

This means investors currently pay ₹20 for every ₹1 the company earned in the past year, and ₹16.67 for every ₹1 it is expected to earn in the future.

What Is Forward Price-to-Earnings (Forward P/E)?

The forward P/E ratio helps investors understand how expensive a share is today based on future expected earnings rather than past profits. It is also called the estimated P/E ratio.

Unlike the trailing P/E, which uses past data, the forward P/E looks ahead, often using the company’s own earnings forecast or estimates from analysts. It helps investors compare a company’s current price with what it might earn in the next 12 months.

• Forward P/E = Current Share Price ÷ Estimated Future EPS
   
• It gives a clearer view of a company's growth potential.
   
• A lower forward P/E may signal undervaluation if growth is expected.
   
• Companies may intentionally understate earnings to beat expectations later.
   
• Analyst estimates may differ from company forecasts, creating confusion.
   
• It is helpful, but should be used along with other financial metrics for better decisions.

So, while the forward P/E offers useful insights, investors should always check other numbers before making any decisions.

What Is Trailing Price-to-Earnings (Trailing P/E)?

The trailing P/E ratio shows how much investors are paying today for ₹1 of a company's past earnings. It is calculated by dividing the current share price by the earnings per share (EPS) from the past 12 months. It is popular because it uses actual reported earnings.

Trailing P/E Ratio = Current Share Price ÷ EPS (last 12 months)
 

Now that we’ve seen how the trailing P/E is calculated, let’s look at what it tells us and where it might fall short.
 

• It uses real earnings, not projections.
• It changes with the stock price, but not instantly with new earnings.
• It may not reflect recent performance or future growth.

If a forward P/E is lower than the trailing one, it signals expected growth. If it’s higher, earnings might drop. While trailing P/E is objective, many investors prefer the forward P/E for forward-looking insights.

Also Read  - How to Analyse Stocks – Methods & Tips for Smart Investing

How to Compare Companies Using the P/E Ratio?

The P/E ratio becomes more meaningful when you compare it with other companies in the same sector, or with broader market indices. Let’s take the example of two energy companies to understand how it works in practice.

Key Limitations of the P/E Ratio

The P/E ratio, though widely used, has its drawbacks. It does not show how much a company might grow in the future. Different companies use different accounting methods, which can make their P/E ratios hard to compare. It also ignores important financial details such as how much debt a company carries or how strong its cash flow is. 

It does not tell us whether the earnings are of good quality or just boosted by one-time gains. Comparing companies across different industries using P/E can also mislead investors, as each sector has its own standards and growth patterns.

Conclusion

The P/E (Price-to-Earnings) ratio shows how much investors are willing to pay for a company’s earnings. It helps compare whether a share is undervalued or overvalued. Investors use it to make informed decisions, but they should also look at other factors before investing.

FAQ’s

1. Why do two companies with the same P/E ratio feel different?
Because their industries, growth rates, and risks vary. A tech firm and a utility company may both have a P/E of 20, but their future potential is very different.

2. Can the P/E ratio be negative?
No, it can’t. If a company reports a loss (negative earnings), the P/E ratio becomes meaningless or undefined.

3. Does the P/E ratio work for new companies?
Not always. New or fast-growing companies may have low earnings or losses, so their P/E ratio may not give a clear picture.

4. How does inflation affect the P/E ratio?
High inflation can lower earnings and raise interest rates, which may lead to lower P/E ratios as investors prefer safer returns.

5. Do all sectors have similar P/E ratios?
No, different sectors have different average P/E ranges. For example, tech companies often have higher P/E ratios than manufacturing firms due to expected growth.