Price to Earnings Ratio

The Price to Earnings ratio or PE Ratio is the relationship between the company’s stock price and Earnings Per Share (EPS). It is a popular ratio that gives investors a better sense of value of the company. The PE ratio shows the expectations of the market and is the price an investor is willing to pay per unit of current earnings (or future earnings, as the case may be).

The most important aspect looked into while investing is the profits of the company. If the company is not able to grow its profits or is not able to earn more, the amount paid for acquiring the stock of that company can take a lot of time to give back a desirable rate of return.

The PE Ratio is also called as an earnings multiple and are categorized in two types i.e. trailing and forward. The trailing PE Ratio is based on previous periods of earnings per share and the forward PE Ratio is when the earnings per share calculations are based on future predicted numbers.

         PE Ratio = Current Stock Price / Earnings Per Share

Where,

Earnings per share (EPS) = Profit attributable to equity shareholders / Number of shares of the company

Profit attributable to equity shareholders = Profit After Tax – Preference dividend

Let us take examples of 3 FMCG companies - Nestle, GSK Consumer and Britannia, to understand PE ratio better:

In the above case, Nestle and Britannia are trading at a higher PE ratios compared to peer GSK Consumer which indicates that GSK is undervalued in comparison to Nestle and Britannia based on PE ratio.

Growth Stocks are companies with a higher PE Ratio indicating a positive future performance and investors have strong expectations for high earnings growth in the future and are willing to pay more for them. Like Nestle and Britannia in the above example.

Value Stocks are companies with a lower PE Ratio like GSK Consumer in the example above. It reflects that the stock is undervalued because its stock price trades lower relative to fundamentals.