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PE ratio in Stock Market

In stock market, Price to Earnings ratio is widely used for stock selection. This ratio generally helps in understanding a company’s true value based on its current value per share. The PE ratio can identify the company’s current value as well as estimate its future growth. This is based on the share prices in relation with the earnings per share. PE ratio is a most commonly used market evaluation tool. It also helps many investors in making several investment decisions.

High PE ratio shows the overvalue of the stock. This makes the investors sell the shares or abstain from buying. In case the PE is low, it shows the undervalue of the stock. For this reason, investors buy them at lower rates to maintain profit.

CALCULATION OF PE RATIO

Calculation of PE is rather simple.

PE Ratio= Market Share Price/EPS

Here, Market share price is the current value of the stock in market. This is easily accessible from the company’s website. Earnings Per Share(EPS) indicates the company’s profitability.

TYPES OF PRICE TO EARNINGS RATIO

There are two types of PE ratio:

  • Trailing PE: Trailing PE generally relies on the past performance of the company. In this, the total EPS over the past year divides the current stock price. It is one of the most dependable metrices for the reason it uses the actual value of company’s profit. This PE helps many investors in making various financial choices. However, there are several downsides for this. Past performance of a company can’t always provide the absolute future actions. Also, it cannot reflect the real-time situations of the companies.
  • Forward PE: Forward PE also called estimated cost to earnings, make use of the approximate future income. This PE compares the current and future incomes of the company. For this reason, it provides a logical image for the company’s profit planning. However, there are certain drawbacks for this. Companies could underestimate PE and thus increase stock prices. This causes the undervalue or overvalue of stocks.

Both PEs have its own advantages and disadvantages. Investors should wisely use them according to your trading strategy and present portfolio.

INVESTMENT STRATEGIES USING PE RATIO

As we know, PE ratio helps in stock selection. High PE ratio normally indicates the overvalue of the price in accordance with the earnings. On the other hand, stock with a low trailing PE is suitable for investment. Even so, if the economy is overall successful, then the high ratios does not indicate overprice. Accordingly, careful evaluation must also be done to ensure better success of the decisions.

CONSTRAINTS

The fact that PE ratio is an important tool, doesn’t mean that it has no limitations. There are some things to keep in mind. One of them is that a high PE in a particular industry could be low in some others. Another one is that an important purchase by a company could increase its PE. Therefore, precise examination should be done before making any essential financial decisions.

CONCLUSION

PE ratio is one of the significant tools for understanding a company’s state. This ratio helps many investors and companies in making various crucial investment decisions. Anyhow in the long run, mindful observation and careful assessment along with PE ratios can help the investors.

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