We provide conceptual clarity and guidance on effective utilization of Price Earnings ratio
Price Earnings Ratio
P/E Ratio = Market Price of Share
Earning per Share (EPS)
As an example, assuming that an organization is presently doing trading at Rs 45 per share and its revenue or earnings over the last one year was Rs 1.85 per share, and then the P/E ratio computed for this stock is 45/1.85=24.32. In many cases, the companies analyze the earnings of the previous four quarters and then compute the yearly earnings per share. This is termed as trailing P/E which is computed by deducting an organization's share value in the initial part of the annual period from its value at the end of the year, making adjustments of stock breaks, if any. In few cases, price earnings can also be considered from the analytical estimates of the upcoming four quarterly periods. This type of price earnings is termed as forecasted or forward P/E. Another not very popular version utilizes the summation of previous two quarters and forecasts of upcoming two quarters. P/E ratio is at times termed as price multiples or earnings multiples.
In principle, the price-earnings ratio is an indicator of the rupee amount that capitalist is expected to make an investment in an organization for achieving one rupee of that organization's revenue. This is the reason why price-earnings are at time termed a multiple reason being it depicts that how much the capitalists are agreeing to invest per rupee of the revenue. In case an organization was presently conducting trade at P/E of 30, the inference is that the capitalist has agreed to invest Rs 30 against Re 1 of the present revenue.
Generally, a high P/E implies that capitalists anticipate richer increase in revenue in the coming years in comparison to organizations with lesser P/E. A lesser value P/E implies that either the organization is presently low in terms of value or it is performing remarkably well as compared to previous patterns. In case an organization has nil revenue or is in a loss, in either of the situations Price-earnings is not applicable. Although negative P/E can be computed, it is not a prevailing practice.
The price-earnings ratio is also visualized as a measure of standardization of the value of one rupee of the revenue across the share market. Theoretically, considering average of Price-earnings ratio spanning over different fiscals, it is possible to generate a standard P/E ratio that can be visualized as a reference and utilized as an indicator that a stock is viable to purchase or not. P/E ratio is the most powerful tool for an effective analysis of the organization's financial strength and sustainability. It is extremely essential to possess a clear conceptual understanding for computing P/E in an accurate manner.
There are certain limitations associated with Price-Earnings Ratio. It is essential to consider these limitations as the capitalists may frequently be misled into believing that a mono numeric shall be the deciding factor to make investments which is never possible.
A basic constraint of utilizing P/E ratios occurs during comparison of P/E ratios of several organizations. The evaluations and progression rates of the organizations differ majorly across various sectors because of varying methods adopted by the organizations to earn revenue and varying time periods in which the organizations earn the revenue. To avoid any discrepancy, P/E must be utilized merely as a means of comparison between organizations of similar sectors since this method of comparing only will result in a fruitful perception. For example, comparison of P/E ratios of an automobile organization and a power organization may misguide the public on which investment is better which is low in reliability.
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