P/E ratio

The price to earnings ratio answers a simple question: how much are investors paying for each rupee the company earns?

Divide the share price by earnings per share. A share at ₹100 with EPS of ₹5 has a P/E of 20 — investors are paying ₹20 for every ₹1 of earnings. The workbook calls P/E the most common stock valuation measure used by analysts.

On its own a P/E says little. Its value is in comparison — with the market, the industry, peer companies, or the same company's past. A company at 18 when its industry is at 22 looks cheap; the same 18 in an industry at 12 looks expensive.

Three versions (Chapter 3, section 3.5.3 A).

For a March year-end company, the workbook's forward P/E for FY19 adds EPS estimates for quarters ending June 2019, September 2019, December 2019 and March 2020.

Judging value. Compare the target's P/E with the market P/E (Nifty 50, Sensex and others), the industry average, or peers. If the target is at 18 and the comparison is at 22, the firm is judged undervalued.

Price level is not valuation. All things being equal, a ₹10 stock at P/E 75 should be considered more expensive than a ₹100 stock at P/E 20.

Limitations the workbook lists.

• Forward P/E relies on analyst estimates that may be inaccurate.
• Companies with negative EPS give P/Es that are difficult to interpret.
• P/E changes constantly and must be recomputed whenever price or earnings estimates change.
• Market and industry average P/Es fluctuate significantly with economic conditions.

Related measures. PEG ratio adjusts P/E for growth (PEG of 1 is fair; below 1 suggests undervalued). EV/EBITDA focuses on operating performance rather than net earnings. Value factor funds favour stocks with low P/E (Chapter 6).

P/E ratio = Market price per share ÷ Earnings per share

Workbook example: ₹100 ÷ ₹5 = 20 times

Illustrative companies and figures; the method is the workbook's.

A distributor compares two FMCG stocks for a client whose PMS approach buys "quality at a reasonable price".

The client says Y is "cheaper because it is only ₹240". That is the trap the workbook warns against: the share price alone says nothing. On P/E, Y is cheaper (24 against an industry 28) — but because its P/E is lower, not because its price is.

Now forward P/E. Analysts expect Company X's next four quarters' EPS to total ₹75:

Forward P/E of X = ₹1,800 ÷ ₹75 = 24

On expected earnings, X looks as cheap as Y. Which one is right depends on whether that ₹75 estimate proves accurate — one of the limitations the workbook lists.

P/E is covered in Chapter 3 (Investing in Stocks), section 3.5.3, under relative valuation, and Chapter 3's sample question 3 asks which ratio compares the price of a stock to the earnings it generates. It reappears in company analysis within the EIC framework and in Chapter 6 (Collective Investment Vehicles) and Chapter 9 (Portfolio Management Process) as the metric behind the value factor.

• A low share price is not a low valuation. ₹10 at P/E 75 is more expensive than ₹100 at P/E 20.
• Trailing = last four quarters; forward = next four expected quarters; current = latest annual EPS.
• Lower P/E than industry or market suggests undervaluation, all else equal.
• Negative EPS makes P/E hard to interpret.
• Forward P/E depends on estimates that may be wrong.
• PEG adjusts P/E for growth — a high P/E can be justified by high growth.
• P/E uses net earnings; EV/EBITDA uses operating profit and is unaffected by capital structure.