What is Price-to-Earnings (P/E) Ratio?

Interested in learning about the price-to-earnings ratio, this metric is also known as P/E Ratio. It gives investors a quick valuation of stock it’s a very common metric that helps you understand if the company is currently over or undervalued in the market.

P/E Ratio = Share Price/Earnings Per Share

What is the P/E Ratio?

P/E Ratio is a valuation metric that compares the stock’s current price to its earnings or profit. It tells you how much of a premium you are currently paying to gain exposure to that company’s profits. The price-earnings ratio can be used to help understand whether the market is currently placing a high or low price on that stock based on how much money and profits the company is generating. In general stocks, with a low P/E ratio something around 10 would imply the stock is currently cheap whereas stocks with a high P/E ratio say 50 or greater imply the price is currently expensive relative to the profit that it makes.

This rule is not always true, because there are many companies exist have a P/E of more than 50 but still give a huge return. P/E ratio may sound somewhat technical but it is a comparison of how people feel about the company and how much time they are ready to pay to earn from that stock. P/E ratio can be calculated of a stock, its related industry, or even an index such as S&P 500 or Nifty 50. If a company’s P/E is higher than its peer then there is a chance that the stock is overvalued.

P/E Ratio Calculation

Although there is no necessity to know how the P/E is calculated as it is already given in the stock pages, the meaning of that particular P/E is most important. Let’s have a look at how you can calculate the P/E ratio, the formula is (price per share ÷ the earnings per share). The output from the P/E ratio calculation will result in what’s called a multiple something like 20 times if you ever hear somebody referring to a stock multiple or earnings multiple they were talking about the P/E.

Consider a company TATA motors, which has a stock price of 60 per share and has an earnings per share of Rs 3 to find the P/E ratio we divide Rs 60 by 3 the TATA motors company price to earnings ratio is 20. What this is telling us, is that the market is currently valuing the shares of TATA motors company at 20 times the amount of their yearly profit. 

So, if you were to buy shares of TATA motors company you would be paying 20 times the amount that they generate in profit for the year. This ratio also implies that it would take 20 years at the current price and profit levels for TATA motors to make enough money to pay back all the shareholders in full for their shares. The P/E ratio shows its strength when you use it to compare different companies within the same industry to get a better idea of how each company is being valued.

P/E Ratio: Comparison With Other Company

Let’s compare two companies here, TATA motors and Volkswagen company both of which provide alternative means of transportation. So we can consider them to be in the same industry, from before we already know that TATA motors have a price per share of Rs 60 and earnings per share of Rs 3 giving us a P/E ratio of 20 times now. 

For Volkswagen company currently have a price per share of 75 with earnings per share of Rs 5, you may be inclined to think that TATA motors are a better value because the share price is only 60 versus the 75 rupees for Volkswagen company, but share price alone does not tell the full story. When we calculate the price-to-earnings ratio for Volkswagen we find that the stock has a P/E ratio of 15 times. So what’s going on here even though Volkswagen has a higher price per share they are also generating more earnings. 

For the shares outstanding what we see is that when we compare the two companies in apples to apple sense with P/E ratio. We find that Volkswagen shares are a better value since the company is more profitable even though Volkswagen shares are 15 more expensive they give you the right to more profits than TATA motors do, you have the right to Rs 5 per share with a profit instead of only the Rs 3 per share in profit the TATA motors offers this is the key to understanding what P/E ratio tells us. You should know that the price-to-earnings ratio is only useful when comparing companies within the same industry as different industries will have different standards.

When it comes to the P/E ratio it would not make sense to compare McDonald’s P/E ratio to Amazon’s P/E ratio. This is because expectations and growth rates within the restaurant sector like McDonald’s are very different than the expectations for a technology company like Amazon. 

McDonald’s might see more consistent profits but at a lower growth rate, whereas amazon’s profits are expected to grow much faster but have the potential for volatility. It would be a much better idea to compare Amazon’s P/E ratio to another tech company like Apple to get an idea of the valuation of each of those companies. With that being said remember that using the P/E ratio for comparison is only useful for companies that operate in similar markets and similar industries.