Price to Earnings Ratio: Formula, Calculation, and Misconception

Price to Earnings Ratio: Formula, Calculation, and Misconception

An investor is thinking of investing in a company. Initially, he thinks about the valuation of the company. And for that he uses a ratio called the Price-to-Earnings ratio.

One day,

My friend: “Give me a stock name for investment purposes”

I replied: “Nestle India”

He said: “No, I will not invest in it”.

I : “Why”

he : “It is over valued. It trades above 60 p / e.”

All investors think the same as my friend. They always avoid investing in high P / E stocks. And that’s why so many multibagger stocks are missed.

But you don’t have to worry. In this complete guide you will learn all these things in detail with examples.

What is the Price to Earnings ratio?

Price-Earnings Ratio, also known as P / E Ratio, or P / E .This ratio is usually used to evaluate companies.

We get the Price to Earnings ratio of any company by dividing the price of that company to the earnings of that company.

Price Earnings Ratio Formula

P/E = Stock Price Per Share / Earnings Per Share

  • The stock price is simply the amount of money it will cost to purchase a share of the company.
  • Earning per share = Net profit/Total share outstanding.

OR

P/E = Market Capitalization / Total Net Earnings

Stock AStock B
Price 100200
Earning1010
Price to Earnings ratio1020

Here,Company A has a P / E of 10 and Company B has 20.

How can we interpret it?

  • Investors are willing to pay Rs 10 for every Rs.1 earned by the Company A. And Rs.20 for company B

OR

  • If Company A’s earnings remain the same for a lifetime, you will get your money back in the next 10 years and for company B the period will be 20 years

Types of Price to Earnings ratio

Typically, Investors use two types of P / E ratios.

  • Trailing(TTM) P/E Ratio
  • Forward P/E Ratio

Let us understand about both in detail


Trailing(TTM) P/E Ratio

As we know,

P/E = Stock Price Per Share / Earnings Per Share

For Asian Paints,

Share Price =

EPS (TTM)= last four quarters of earning.

In India , all companies publish earning data 4 times a year.

  • Q1-June quarter
  • Q2-September quarter
  • Q3 December quarter
  • Q4-March quarter

Scenario : 1

Now, You want to calculate the EPS of Asian paint in January 2020. Then the last four quarters are :

Trailing Price to Earnings ratio calculatio
MonthEPS
December -20197.97
September -20198.58
June – 20196.83
March -20194.92
Total28.95

Price to Earning Ratio (TTM) =1542/28.95

=53.26


Scenario-2

Now, You want to calculate P / E (TTM) in July 2019 instead of January 2020

So, EPS(TTM) is

Trailing price to earnings ratio calculatio
MonthEPS
June 196.83
March 194.92
December 186.63
September 185.12
Total23.5

Price to earning ratio(TTM) = 1542 / 23.5

=65.61


Forward P/E Ratio

For Forward P/E ratio, EPS is assumed to be for the next year.

So for different people, EPS will be different and so P/E ratio

Suppose, two investors are there Mr. A and Mr B.

  • Mr. A: Asian Paints EPS will increase by 20% next year.

And

  • Mr. B : It will increase by 10%.

Then, the Forward P / E will be

(Note: Last year EPS was Rs.30)

Mr AMr.B
Share Price15001500
EPS ( Forward)3633
Forward P/E41.6645.45

High P/E stock and Low P/E stock

In general, there is a belief in India that if a stock trades at a P / E above 20, it is a high P / E stock. And if it trades below 20, it is low P / E stock.

High P/E stock

Why does a stocks trade at high P/E ?

  • In India, if a company has all the following characteristics, it always trades at a high P / E.
    • Market Leader in Industry
    • Secular business in nature
    • High ROCE
    • High ROE
    • Dividend Payout Regularly
    • Good Corporate Governance

Example : Asian Paints Ltd

YearPrice To Earnings Ratio
201024.45
201130.35
201233.74
201345.57
201445.23
201561.4
201648.95
201753.95
201854.04
201966.19

Asian Paint has been trading at a high P / E since 2010.

But Why?

This is because of below factors :

  • Good Corporate Governance :
    • As we know, there has been no issue or fraud in Asian Paint to date. It shows good corporate governance.
  • Secular Business Growth :
    • From the chart, you can see that the revenue and profit of Asian Paints have been steadily increasing over the last 10 years. It shows secular business growth.
High price to earnings ratio stock(Asian Paints)
  • High Return on capital employed :
    • In the last 10 years, the ROCE of Asian paints has been more than 15% per year.
YearReturn on capital employed
201071%
201159%
201253%
201350%
201447%
201545%
201644%
201740%
201837%
201935%
  • Dividend Payout Regularly :
    • The company has declared a dividend of about 30% of its profits in the last 10 years.
YearDividend Payout (%)
201031%
201136%
201239%
201340%
201442%
201542%
201641%
201751%
201841%
201947%

Misconception about High P/E stocks

Most investors believe the P / E ratio is high, the stock is overvalued. and investing in that stock will not give you a good return in the future.

Let’s see how much return Asian paint stock has given in terms of CAGR till 2019 if we have invested in Asian Paints in any year.

YearP/EShare price Return in CAGR
till 01-04-2019
20091933.88%
201024.4524.86%
201130.3524.94%
201233.7424.25%
201345.5720.20%
201445.2322.69%
201561.4016.07%
201648.9519.69%
201753.9516.86%
201854.0429.68%

From the chart above, you can see that if you have invested in Asian Paints on any P / E, you have got a return of more than 15%. In most years you get a return of more than 20% which is outstanding.

Low P/E Stock

Why does a stocks trade at low P/E ?

  • In India, if a company has all the following characteristics, it always trades at a low P / E.
    • Cyclical in Nature
    • Low ROCE
    • Low ROE
    • No Dividend Payout
    • Bad corporate Governance

Example : Tata steel Ltd

YearPriceEPSP/E
20105730No P/E ( Because company made loss)
201159779.307.52
201243546.189.41
20133210No P/E
201432531.1910.42
20153320No P/E
20162420
20174710
2018675117.345.75
201950789.255.68
  • Cyclical In nature :
    • In some years, the profit was positive, and in some years, it was negative. It reflects the cyclical nature of the business.
Low price to earnings ratio stocks(Tata steel)
  • In some years, the profit was positive, and in some years, it was negative. It reflects the cyclical nature of the business.
  • Return On capital employed :
    • Here, ROCE does not exceed 15% in any given year. And that’s bad for any company.
YearReturn on capital employed
20105%
201115%
20129%
2013-1%
201410%
20151%
20161%
20177%
201812%
201914%
  • Dividend payout :
    • The company declares a dividend if it makes a profit. Here the company does not make a profit every year. So it has declared a dividend in just a few years.
YearDividend Payout (%)
2010-35%
201113%
201222%
2013-11%
201427%
2015-20%
2016-203%
2017-23%
20189%
201915%

Misconception about Low P/E stocks

Investor believe that if they invest in low P/E stocks,it will produce better returns in future

Look at the returns delivered by Tata Steel in the past.

Someone had invested in Tata Steel in 2011 at P / E 7.92.

Now, look at the returns that Tata Steel has given since 2011

Tata steel return in last 10 year
  • No return in last 10 year

Conclusion : Every Low P/E does not mean undervalue stock.

Historical Sensex Price to Earnings Ratio

YearP/E
2000-200123.89
2001-200216.55
2002-200314.51
2003-200416.18
2004-200516.56
2005-200616.98
2006-200720.72
2007-200822.61
2008-200915.66
2009-201020.13
2010-201121.60
2011-201218.50
2012-201317.09
2013-201417.38
2014-201518.73
2015-201620.18
2016-201720.62
2017-201823.78
2018-201923.71
2019-202026.44
2020-202119.05

When does P/E ratio Useful?

Investment using Sensex P/E ratio :

Why does people invest in the stock market ?

  • To get maximum return

Large investors such as FIIs, DIIs, and other large investors use the Sensex P / E to identify the market valuation.

See the table above, the P / E of the Sensex has been between 14 to 25 since 2000.

If you make an average, it will come around 18.

If the market is above 18 P/E, you can say that it is overvalued and you can sell and if the market is below 18 it is in the buy zone.

Take the example of Asian paints.

We will consider two cases here.

Case-1 : The Sensex P / E was 22.61 in 2007-2008

and

Case-2 : the Sensex P / E was 15.66 in 2008-2009

Now look at the returns generated in two different cases.

If you had invested Rs 1,00,000,then

Asian paints last 10 years return

You could have made Rs 7.5 lakh more by inspecting the P / E of Sensex.


To identify undervalue of a high quality business :

  • A high-quality company always trades at high P / E.If you do not know how to calculate the intrinsic value of a company, you can simply compare the P / E of that company with its historical average. You can invest in it when it falls below its historical average. This is a very simple way to invest in a high-quality company.

HUL traded at a very high P / E in 2000.

Sometimes your company is OK but you get into it at a high P / E.

One such company is Hindustan Unilever. HUL is bluechip of the bluechip company. In the year 2000, it traded more than 200 p / e.

What if someone entered HUL in the year 2000 ?????…….

Share price performance between 2000-2010.

YearShare priceReturn
2000230
20102380.34%

No return in 10 years.

Had a fundamental problem with the company?

  • No

The only stock was going through a time correction. Let’s see what happens if you continue to invest in HUL for another 10 years

HUL last 20 years return

Share price-performance Between 2010-2020

YearShare PriceReturn
2010238
2020225525.22%

Share price performance Between 2000-2020

YearShare priceReturn
2000230
2020225512.09%

You would have got a CAGR 12.09% return in the last 20 years which is very good. In addition, you would also get a dividend of 1.5% -2% per year.

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