What is the importance of PE Ratio?

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Australian Economy, Macro Economics

Price-to-earnings (PE) ratio is one of the most widely used financial ratios in the world in equity parlance. Usually, investors love to check the PE multiple of the stock while analysing it before making an investment.

PE ratio helps an investor to calculate the price multiple that he might be willing to pay for a company’s earnings and is calculated by current market price of the share divided by the earning per share (EPS). There are two types of PE multiples, namely, a Forward PE and a Trailing PE. The forward PE ratio is a widely accepted ratio in valuation because it is based on future earnings of the company and is generally calculated by the current market price of the share divided by estimated future earnings per share of that company. On the other hand, Trailing PE is based on the past earnings, and it is generally calculated by current market price of the stock divided by EPS over the previous 12 months. Since, it takes past earnings of the company into consideration, the future earnings prospects of the company might not be evaluated properly. Let’s understand the simple PE ratio derivation through an example, suppose Collins Foods Limited (ASX: CKF) is trading at $5.17 and its earnings per share is $0.241, then it’s PE ratio would be around 21x. That means investors are willing to pay 21 times to earn one dollar of earning.

The significance of PE ratio is to understand how cheap or expensive a stock is. Lower P/E ratio is considered to be cheap and gives a hint of a buying opportunity. But it also indicates that the market is not too much positive on the growth of the company and the same is looked upon as an ‘Undervalued’ stock. Whereas, higher PE means that investor is paying more for each unit of income, indicating that the stock is more Expensive or Overvalued. Nonetheless, higher PE sometimes is also indicative of good growth stocks.

During the Marco economic downturn such as rise in inflation, increase in interest rate, industry slowdown, etc., it is very difficult to get a clear picture about the valuation of stock. As a result of this, P/E ratio gets skewed.

PE ratio also gives an idea of key financial fundamentals of the company such as past performance, future growth and risk. If the company has robust track record, then it would have higher PE multiple relative to a company which has had an irregular performance. PE ratio is also dependent on capital structure of the company. High capital-intensive industry gets lower PE multiple than low capital-intensive industry. Moreover, high and stable dividend paying stocks enjoy higher PE multiple because of strong fundamentals and the company’s commitment to reward its shareholders.

Eventually, PE ratio is a powerful tool to determine whether the stock is being traded at the exchange at a premium or a discount with respect to the underlying value of the business. The general thumb rule of investing into equities is to watch for this ratio and compare with historical performance and industry peers to make a decision on whether the investment is worth a punt and whether the stock under scrutiny is a value or a growth stock.


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