PE ratio defines how much investors are willing to pay to buy the shares of the company, for every Rs1 profit earned by the company.
Formula
PE Ratio = Earnings per share / Current Market Price
Example
Company XYZ has the EPS (Earnings per Share) of Rs 10 and the current market price is Rs 200. The PE ratio is 20.
For every Rs 1 of net profit (earnings), the investors are willing to pay Rs 20 to buy the company.
How to Use practically
Generally, low PE stocks are considered to be undervalued and high PE stocks are considered overvalued. But this may not be true.
PE ratio should be used in conjunction with the growth rate and ROIC of the company to get a better perspective of the valuation of the company.
PE ratio cannot be used for loss-making high growth new tech companies which are yet to make any meaningful profit. (You can use Market Cap to Sales ratio to value these companies.)
The easiest way to use a PE ratio is to compare it to a benchmark, such as another company in the same industry, the entire market, the industry average, or the same company at a different point in time.
A company that’s trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels, and growth rates, all of which affect the price to earnings ratio.
However comparing a stock’s current P/E with its historical Price to earnings ratios can be useful, especially for stable firms that haven’t undergone major shifts in their business.
If you see a solid company that’s growing at roughly the same rate with roughly the same business prospects as in the past, but it’s trading at a lower P/E than its long-term average, you should start getting interested.