PE Ratio Explained for Indian Investors

PE Ratio Explained for Indian Investors

While  investing shares, sooner or later you are going to come across the symbol PE which  It stands for the price-earnings ratio

In the P/E ratio, the ‘P’ stands for the current share price and the ‘E’ stands for the earnings (post-tax profits) per share of the company. It establishes a direct relationship between the current price of a company’s shares and its after-tax earnings expressed on a per share basis. The figures for calculating the earnings per share, or EPS, are normally taken from the company’s latest known results for a full 12-month operating period. The P/E and the EPS are calculated as given under:

P/E = Current market price of the share (P)/After-tax earnings per share (EPS)

This ratio is also known as  price-earnings multiple. The PE is easily the most and widely-used of all investment indicators.

It is difficult to find any kind of investment literature which does not contain frequent references to the P/E ratio.

However, despite its wide usage, it is not a completely reliable or infallible guide for picking stock market winners. Moreover, it cannot always be exclusively depended upon.

Use of PE ratio

A high PE ratio normally indicates high investor confidence in the future prospects of a company. Investors expect the sales and profits of the company to grow rapidly in the future. This expectation makes them willing to pay a higher price for the company’s shares.

Conversely, a low PE ratio normally indicates low investor confidence, or  complete absence of investor confidence in the future prospects of a company. Investors do not expect the company’s profits to grow rapidly in the future.

This is how the PE becomes a measure of investor confidence in the company. One quick look at the current P/E ratio and you can have judgment of what the thinks about a particular company, its management and its future prospects.

The blind and unthinking use of the P/E ratio can be very deceptive and misleading. A high P/E ratio need not always imply high investor confidence and rising corporate profits pointing to high growth and large capital gains in the future. It could also reflect misplaced investor confidence or an inflated share price caused by speculative excesses and a market over-reaction. A high PE may also signal a warning pointing towards falling corporate profits and a market that is slow recognize this .

On the other hand, a low P/E ratio may not always reflect poor investor confidence or point towards a discarded share. It could also mean an undiscovered share with fast-growing profits and a bright future. Some of the best and most spectacular high-growth opportunities are often found in undiscovered companies with low P/E ratios.