Concept of P/E

Every time we see a news reader suggesting a stock to sell or buy they say the P/E for this stock is very high or lower than the industry averages or when we read an article we come across the word "P/E". What is P/E? Why is it important? What can we know from it? Let me start explaining in you in simple terms.

A P/E is nothing but an ratio. It stands for "Price to Earning" ratio. Now we know the expansion of the word P/E. We also get a hint from it that it has do something with the Price (Share Price) and the Earnings (Net Profit / Income) of the company. Now that we got a hint what it is lets define what's "Price to Earning" ratio.

The P/E ratio (price-to-earnings ratio) of a stock (also called its "P/E", "PER", "earnings multiple", 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. So, it shows the relations of how much you are paying for that one share of a company with regards to the earnings of the company.


P/E = Price per share / Annual Earnings per share


The P/E Ratio is expressed in number of years.

In this ratio we have the denominator as Annual Earning per share or simply it is referred to as EPS (Earnings Per Share). Aha! We have heard this word also many times. But, What is EPS?

Earnings per share is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. In simple terms it is nothing but the Net income / Earnings of the company for the financial Year divided by the outstanding number of shares. What's this term "Outstanding number of shares" you must be wondering. "Outstanding shares" are nothing but the shares that are issued by the company. These include shares that can be traded i.e that can be bought and sold freely through the stock exchange (also includes restricted shares or share that need special permission before being transacted).

So, now lets say that the Price of the share of A Ltd is Rs. 2000 and it has an EPS of 20, then the P/E is 100 (2000/20).

What does a P/E of 20 tell you?
It tells you that

* The share price of A Ltd is 20 times its earnings
* It will take 20 years to recover the price you paid to buy the share of A ltd (i.e. "number of years of earnings to pay back purchase price") without taking into account the time value for money
* You are paying Rs.20 for every rupee of earnings of A Ltd


Again we should be comparing with the industry averages to see if A Ltd's P/E is in significant discount or premium. Say A Ltd is a pharmaceutical company. Then, we should see the pharmaceutical industry's average P/E and see how A Ltd's P/E stands against it.

The P/E we talked here was with respect to Trailing P/E i.e. Earnings for the last 12 months is taken into consideration, historical data. P/E can also calculated using estimates of earnings of the next 12 months in future. This is called as Forward P/E.

Now, the nest question is will the P/E tell me whether the stock is cheap or expensive. P/E just gives an idea but whether a particular P/E is high or low depends on many things and there is no perfect answer to that. A P/E depends on the growth rates of the company, industry it is in, expectations form the companies etc as all these factors get reflected in the share price.

So, use P/E just as a viewpoint with other parameters when you buy a share but not as a guide.

The other interesting part which i came across is when you take a 10-year period and calculate the P/E you might find that the company's P/E has a range and thus you may put a band on when to enter and when to exit using the P/E.

We have just touched on what's a P/E and tried to understand a little. Hope you enjoyed reading it and got some idea about it.

Silla Nodigal

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