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Importance of PE Ratio For Investing in Mutual Funds
Importance of PE Ratio For Investing in Mutual Funds
Importance of PE Ratio For Investing in Mutual Funds
The price-earnings ratio, often known as the PE ratio, P/E ratio or price to earnings ratio, is a
market prospect ratio. It calculates the market value of a stock of a company, as relative to its
earnings by comparing the market price per share by the earnings per share (EPS). This ratio
shows what the market is willing to pay for a stock based on its current earnings.
PE is a popular ratio that gives investors a better sense of the value of the company. It shows the
expectations of the market and is the price you need to pay per unit of current earnings (or future
earnings, as the case may be).
We want to know about earnings evaluating a company’s stock because we want to know how
profitable a company is and how profitable it will be in the future. This ratio helps us evaluate
what a stock’s fair market value should be, by predicting future earnings per share.
Companies with higher future earnings are usually expected to distribute higher dividends. Or
more possibilities of increase in stock in the future.
Moreover, if the company doesn’t grow much and the current level of earnings remains constant,
the P/E can be understood as the number of years it will take for the company to pay back the
amount paid for each share.
PE Ratio Formula
The price-earnings ratio is calculated by dividing the market value price per share by the
earnings per share.
This ratio is usually calculated at the end of each quarter when quarterly financial statements are
issued. And is calculated at the end of each financial year with the annual statements.
In any case, the fair market value is equal to the trading value of the stock at the end of the
current period.
The EPS ratio is also calculated at the end of the period for each share outstanding. A Trailing
PE ratio occurs when the EPS is based on the previous period. And Leading PE ratio is the one
when the EPS calculation is based on future predicted numbers. A justified PE ratio is measured
by using the dividend discount analysis.
Examples
Suppose the current market price of the stock of A Ltd. is Rs. 100 and its EPS is Rs. 10.
The Price Earning Ratio of A Ltd. will be calculated as follows:
P/E = 100/10 = 10
The P/E ratio of A Ltd. is ten times, which means that investors are willing to pay Rs.10 for
every rupee of earnings.
B Ltd’s stocks are currently trading at Rs. 50 a share and its EPS for the year is Rs. 5. B
Ltd’s P/E ratio would be calculated like this:
P/E = 50/5 = 10
As you can see, the ratio is 10 times. This means that investors are willing to pay Rs.10 for every
Rupee of earnings. In other words, this stock is trading at a multiple of ten.
Because the current EPS was used in this calculation, this ratio would be called a Trailing price-
earnings ratio. If a future predicted EPS was used, it would be considered a Leading price-
earnings ratio.
Interpreting PE Ratio
1. High P/E Ratio
Companies with high PE ratios are often considered to have growth potential. It means that the
market has higher expectations for future earnings growth. And that the investors are willing to
pay more for them as it indicates a positive future performance. However, the problem with high
P/E is that growth stocks are often unpredictable. It puts a lot of pressure on companies to do
more to maintain their higher valuation. Therefore, investing in growth stocks may get to be a
risky investment. Also, for some corporates, it can even be interpreted as an overpriced stock.
2. Low P/E Ratio
Companies with low PE ratios are often considered to have underrated stocks. Or that the price
of their stock is relatively small. A company with a low PE ratio is usually indicative of a weak
current as well as future performance. The lower pricing of stock attracts investors to buy more
before the market corrects it. And when it does, investors make a profit because of the stock
price increase. However, this could be a poor investment option.
3. Justified P/E Ratio
The Justified P/E ratio is calculated independently of the normal P/E. Unlike the regular P/E
ratio, it is not based on the observed price. Instead, inputs such as expected dividend, growth
rate, earnings, and cost of equity are used to estimate the P/E. These are based on future cash
flows.
Therefore, these two ratios produce two different results.
This is also termed as being “justified” by using the Gordon Growth Model.
If the P/E is lower than the justified P/E ratio, it means the company is undervalued and
purchasing that stock will result in profits, if the Alpha Ratio is closed.
Calculating PE Ratio