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Price Earnings Ratio (P/E Ratio) is the most commonly used method of valuing companies. It is arrived at by dividing the current market price of the equity share by its EPS.
P/E Ratio can be calculated by dividing the current share price by the trailing 12 months EPS i.e. reported EPS of the last 4 quarters. A high P/E ratio indicates that the investors are expecting the earnings (and accordingly the price of the company’s shares) to grow at a faster rate and vice versa.
So what does the P/E Ratio indicate?
Simply put, P/E Ratio indicates how much the market is willing to pay today, to get each rupee of the future earnings of the company.
Example: Company A trades at a market price of Rs. 90 and an EPS of Rs. 10 (EPS for FY 2012). The P/E ratio of Company A works out to 9 (i.e. 90/10). Assuming that Company A’s EPS will remains stable in future, it will take 9 years for the investor to realize his investment of Rs. 90.
However, the market expects the earnings of Company A to grow at a higher rate in future. Let’s assume that Company A’s earnings are expected to grow at 35% (year on year) for the next few years. How long will it take for the investor to realize his investment of Rs. 90? As shown in the table, if Company A’s EPS grows at 35% (y-o-y), the investor will realise his Rs. 90 at the end of FY 2016 (i.e. in 4 years).
What is an ideal P/E Ratio?
The answer to this question depends on the growth potential in the company’s earnings. If analysts believes that the earnings will grow at a higher rate in future, they will be willing to pay more to buy equity in the company and such a company will command a higher P/E and vice verssa.
Companies in some sectors command a high P/E Ratio in comparison to companies in other sectors. For example, technology and FMCG companies command higher P/E ratios since it is believed that their earnings (and accordingly the EPS) grow at a faster pace.
Forward P/E Multiple: When analysts talk of forward P/E Multiple, what do they mean? Forward P/E Multiple is arrived at by dividing the current market price of the share by its expected EPS at a future date. In the above, assuming a 35% EPS growth, Company A’s EPS will be 24.60 for FY 2015. Thus at the current price of Rs. 90 the stock is said to have a forward P/E multiple of 3.66 times its 2015 earnings (i.e. 90/24.60).