How P/E Ratio plays an important role in investing…!!
Financial ratios play an important role in stock market investing. It helps to break down information about a company’s financial statement. This information helps to know a lot about the company’s profitability, debt repayment, and operational efficiency etc. Based upon that, an investor can assume whether the company is undervalued or overvalued. One such ratio which helps in analyzing the company is the Price to Equity ratio (P/E) ratio.
Price to earnings ratio is one of the most popular tools used for stock selection. It gives the investors an idea if the stock has growth potential in the future or not. If the P/E is high, it means that the stock is overpriced and if the P/E is low, it means that the stock is under-priced. Let’s break the Price to Equity ratio for a better understanding:
Price to Equity ratio = Market Value per Share /Earnings per Share
In order to calculate, price to earnings ratio, one needs to divide market value per share by earning per share.
Earnings per Share = Total Earning / Total no of outstanding share.
A company with high EPS means that it is in a good position to distribute the profit to its shareholders.
Significance of Price to Equity ratio:
Price to equity ratio helps in understanding the growth potential of a company. Let’s try to understand through an example, assume there are two companies ‘ A’ and ‘ B’ working in the same sector. If the PE of ‘A’ is 25 and that of B is 28, then ‘A’ is a better buy, as the market price has not gone up. But at the present time, ‘ B’ is considered to show higher growth prospects as compared to ‘ A’.
A high PE simply means that investors are optimistic about the future earnings of the company. They are willing to pay more. It also shows that the stock is overvalued. There are mainly two types of PE i.e. Trailing PE and Forward PE. In the case of trailing PE, earnings of the last 12 months are taken into consideration, whereas in the forward PE, earning estimates over the next 12 months are taken into consideration. Based on the PE, the stocks are divided into two parts:
Growth Stocks: These stocks are mainly good quality companies whose earnings are expected to continue to grow at an above-average rate relative to the market.
Value Stocks: These stocks are having a low price to earnings ratio. They are considered as undervalued stocks that have a lot of potential to grow in the future. Any investor who believes in value investing always looks for value stocks.
But an investor should always consider other financial ratios rather than solely dependent upon the P/E ratio.
*Disclaimer: investment in securities market are subject to market risks, read all the related documents carefully before investing