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Price to Earning Ratio: Definition and Formula

Sarmaaya Desk
Sarmaaya Content Team

Key Takeaways

  1. Price to Earning Ratio (P/E ratio) is used as a mean of determining stock value of a particular company
  2. Purpose of a P/E ratio is to help investors determine future earnings growth along with market value of stocks
  3. High Price to Earning ratio indicates overvaluation
  4. Low Price to Earning ratio indicates undervaluation

What is Price to Earning Ratio (P/E Ratio)?

The price earning ratio is one of the most widely used metrics in determining stock valuation. It describes the cost of gaining $1 in profits. P/E ratio compares the company’s stock price with its earnings per share thereby being extremely helpful to the investor in figuring out the value of the company’s stock.

Another use of P/E ratio for the investors is that it helps them determine future earnings growth along with the stock’s market value. To understand this better, if earnings are expected to increase, the investor might expect the company to increase their dividends as well because increase in dividends and earnings often results in a subsequent increase in stock prices.

How to calculate Price to Earning Ratio?

Investors look at a company’s P/E ratio when they want  to determine if the share price precisely represents the expected earnings per share. The formula for calculating P/E ratio is as follows:

Price to Earning Ratio (P/E Ratio) =  Market value per share (Stock price) / Earning per share

The stock price for different companies are easily available on portfolio.sarmaaya.pk

Earnings per share in easier terms is a part of the company’s net income that would be earned if all the profits were to be paid to its shareholders, thus showcasing the financial strength of the company to the investors and analysts.

For example:

Nishat Mills Stock Price = PKR 107.07  

Earning per share (EPS) = 22.2

 

 P/E ratio = 107.7/22.2

 P/E ratio = 4.85

 

Understanding what P/E Ratio means

P/E ratio is sometimes referred to as the price multiple because it indicates the dollar amount an investor is expecting to invest in the company in return for $1 from the company’s earnings. A high P/E ratio indicates that the company’s stock price is higher relative to its earnings, indicating that it may be overvalued. Conversely, a lower P/E ratio value indicates that the stock price is lower relative to the  company’s earnings, thus indicating that it may be undervalued.

It is however important to note that in order to determine undervaluation and overvaluation of a stock, the comparison should be held between stocks of the companies from the same industry group. This will help develop a benchmark, which in turn will help the investor in their analysis. We do this because growth rates and valuations may be significantly different across different sectors due to contrasting ways that different companies earn money and with differing timelines. So if you compare the P/E ratios of the Technology sector with the beverage sector, the results would be vastly different, leading to inaccurate assumptions that one investment is better than the other.

Moreover, setting a benchmark helps the investors develop a trend analysis and understand the overall industry’s standing. A high P/E ratio of an individual company would be a cause of concern. However, if the industry average itself is very high, then the investor should be careful in making their investment in any company in the given industry.

 




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