P/E Ratio Explained: How to Use It While Selecting Stocks?
When you start analysing stocks, one of the first numbers you will often see is the P/E ratio.
You can find P/E ratios on stock-market websites, financial platforms and company comparison pages. At first, the concept seems simple. For example, a stock with a P/E of 15 may look cheaper than another stock with a P/E of 40.
But does a lower P/E always mean a better investment?
No.
A high P/E may mean investors expect strong future growth. A low P/E may mean the stock is undervalued, but it can also indicate that investors expect the company’s profits to fall. The P/E ratio is useful, but it should be used along with other financial information.
What Is the P/E Ratio?
P/E stands for Price-to-Earnings Ratio. It compares a company’s current share price with its earnings per share (EPS).
The basic formula is:
P/E Ratio = Market Price per Share ÷ Earnings per Share
Example: Suppose a company’s share price is ₹300 and its EPS is ₹20.
P/E would be:
₹300 ÷ ₹20 = 15
So, the stock is trading at 15 times its current earnings. In simple terms, investors are currently willing to pay ₹15 for every ₹1 of the company’s annual earnings.
However, this does not mean you will recover your investment in exactly 15 years. Share prices, profits, dividends and business conditions can all change.
What Is Earnings Per Share (EPS)?
Earnings Per Share (EPS) tells you how much of a company’s profit is attributable to each equity share.
A simplified formula is:
EPS = Profit Available to Equity Shareholders ÷ Number of Outstanding Equity Shares
Example: Suppose a company earns ₹50 crore in profit and has 5 crore outstanding shares.
Its EPS would be:
₹50 crore ÷ 5 crore shares = ₹10 EPS
If the share is trading at ₹200:
P/E = ₹200 ÷ ₹10 = 20
This means the stock is trading at 20 times its earnings. When comparing P/E ratios, make sure you are comparing similar figures. Data may differ depending on whether the calculation uses basic or diluted EPS and standalone or consolidated financial results.
What Does a High P/E Ratio Mean?
A high P/E generally means investors are paying a higher price for each rupee of current earnings. This can happen when investors expect the company to deliver strong future growth.
A company may have a high P/E because of:
- Strong expected profit growth
- A trusted brand
- Good management
- High return on capital
- Low debt
- Strong competitive advantages
- A large market opportunity
- Stable and predictable earnings
Example: Suppose Company A earns ₹10 per share and its stock price is ₹500.
Its P/E is:
₹500 ÷ ₹10 = 50
A P/E of 50 may look expensive, but investors may be willing to pay this price if they believe the company’s earnings can grow significantly in the future.
However, high P/E stocks also carry a risk.
When investor expectations are already very high, even a small disappointment in earnings or growth can cause the stock price to fall sharply.
A great company can still be a poor investment if you buy it at an unreasonable price.
What Does a Low P/E Ratio Mean?
A low P/E means the stock is trading at a lower multiple of its current earnings. This can sometimes indicate that the stock is undervalued. But there may also be a reason why investors are unwilling to pay a higher price.
A company may have a low P/E because:
- Profits are expected to decline
- Debt is high
- Growth is weak
- The industry is facing problems
- Management confidence is low
- Current profits are unusually high
- Investors have lost confidence in the company
Example: Suppose Company B earns ₹20 per share and trades at ₹160.
Its P/E is:
₹160 ÷ ₹20 = 8
At first glance, this may look cheap. But if analysts expect the company’s earnings to fall to ₹8 per share next year, the stock may not be as cheap as it appears.
Therefore:
A low P/E should encourage further research, not an automatic purchase.
Trailing P/E vs Forward P/E:
You may come across two common types of P/E ratios.
Trailing P/E: Trailing P/E is based on the company’s earnings from a recently completed period, commonly the previous 12 months. Because it uses reported earnings, it is based on actual financial results.
However, past earnings may not accurately represent the company’s future earnings.
Forward P/E: Forward P/E is based on estimated future earnings.
For example:
- Current share price: ₹400
- Previous year’s EPS: ₹10
- Expected future EPS: ₹20
Trailing P/E:
₹400 ÷ ₹10 = 40
Forward P/E:
₹400 ÷ ₹20 = 20
The forward P/E looks much lower because earnings are expected to increase.
However, remember that future earnings are only estimates. If the expected growth does not happen, the stock may turn out to be more expensive than expected.
How Should You Compare P/E Ratios?
A P/E ratio becomes more useful when you compare it with relevant companies and historical numbers.
1. Compare With Similar Companies:
Try to compare companies operating in the same industry.
For example:
- Compare a bank with other banks.
- Compare an IT company with other IT companies.
- Compare an automobile company with similar automobile companies.
Different industries have different growth rates, risks and business models. A P/E of 30 may be expensive for one industry but normal for another.
2. Compare With the Sector Average:
The industry or sector P/E can provide additional context. If a company has a P/E significantly above its sector average, ask:
Does its growth and financial performance justify the higher valuation?
If its P/E is below the sector average, ask:
Is the stock genuinely undervalued, or is there a problem with the business?
3. Compare With the Company's Historical P/E:
You can also compare the current P/E with the company’s past valuation. Suppose a company normally traded at a P/E between 15 and 20 but is now trading at 30. The stock may be more expensive than its historical valuation.
On the other hand, if it normally traded between 30 and 40 and is now trading at 25, it may appear relatively cheaper. However, historical P/E should not be used blindly. The company’s growth, debt, business model and profitability may have changed.
Why Can the P/E Ratio Be Misleading?
The P/E ratio is based on earnings. If earnings are unusual, the P/E can give a misleading picture.
1. One-Time Profits:
Suppose a company sells a property and earns a large one-time profit. This increases reported earnings and may make the P/E look unusually low. But the company’s regular business may not have improved at all.
2. Cyclical Businesses:
Some industries experience large changes in profits depending on economic or commodity cycles.
For example, companies in metals, commodities or shipping may earn very high profits during favourable periods.
Their P/E may look extremely low when profits are near their peak. When the cycle changes and profits fall, the stock may no longer look cheap.
3. Accounting Differences:
Reported profits can be affected by:
- Depreciation
- Provisions
- Exceptional items
- Accounting policies
Therefore, investors should also examine cash flow and other financial measures instead of relying only on reported profit.
4. Share Buybacks and New Shares:
A company buyback reduces the number of outstanding shares. This can increase EPS even if total company profit remains unchanged. On the other hand, issuing additional shares can dilute EPS. These changes can affect the P/E ratio.
5. Companies With Losses:
If a company is making a loss, its EPS may be negative. In such cases, the P/E ratio is generally not meaningful. A negative P/E should not be interpreted as an extremely cheap stock. It usually means the company currently has negative earnings.
Can P/E Tell You If a Stock Is Cheap?
The P/E ratio can help you understand valuation, but it cannot tell you by itself whether a stock is cheap or expensive.
For example:
- A stock with a P/E of 50 may be reasonably valued if its profits are growing rapidly.
- A stock with a P/E of 10 may be expensive if its earnings are about to fall sharply.
Before making an investment decision, also look at:
- Revenue growth
- Profit growth
- Debt
- Cash flow
- Return on equity
- Return on capital employed
- Profit margins
- Management quality
- Competitive advantage
- Industry outlook
- Company valuation
No single financial ratio can tell you everything about a business.
What Is the PEG Ratio?
The PEG ratio compares the P/E ratio with the expected earnings growth rate.
A simplified formula is:
PEG Ratio = P/E Ratio ÷ Expected Earnings Growth Rate
Example
Suppose:
P/E = 30
Expected earnings growth = 20%
PEG ratio:
30 ÷ 20 = 1.5
The PEG ratio tries to provide additional context by considering growth along with valuation.
However, it also has limitations because future growth estimates may be incorrect.
Therefore, use PEG as an additional valuation tool rather than making an investment decision based only on it.
Practical Example: Comparing Two Companies
Let’s compare two companies from the same industry.
Company A:
- Share price: ₹600
- EPS: ₹20
- P/E: 30
- Expected profit growth: 20%
Company B:
- Share price: ₹300
- EPS: ₹20
- P/E: 15
- Expected profit growth: 5%
Based only on P/E, Company B looks cheaper. But Company A is growing much faster. The higher P/E of Company A may be justified if it can maintain its stronger growth for several years.
However, you still need to investigate whether the expected growth is realistic.
This is why P/E should be the beginning of your analysis, not the end.
Frequently Asked Questions:
No.
A high P/E can be reasonable when a company has strong and sustainable growth. The risk increases when the high valuation depends on unrealistic expectations.
No.
A low P/E may indicate an undervalued company, but it can also indicate falling profits, weak growth, high debt or other business problems.
There is no single P/E ratio that is considered good for every company. The appropriate P/E depends on the industry, growth rate, profitability, financial strength, interest rates and overall market conditions.
Yes, a company with negative earnings may produce a negative mathematical P/E.
However, P/E is generally considered not meaningful when a company is loss-making.
You can, but comparing the company with similar businesses and its sector is often more useful. A company’s business model may be very different from the companies that make up a broader market index.
Yes, P/E can be one of the ratios considered when analysing banks.
However, investors often also examine factors such as:
- Price-to-book ratio
- Return on equity
- Asset quality
- Net interest margin
- Capital adequacy
The right combination of ratios depends on the type of business being analysed.
Conclusion:
The P/E ratio is one of the simplest and most widely used tools for understanding stock valuation. It tells you how much investors are currently willing to pay for each rupee of a company’s earnings.
But remember:
- Low P/E does not automatically mean cheap.
- High P/E does not automatically mean expensive.
Use P/E along with:
- Company growth
- Profitability
- Debt
- Cash flow
- Management quality
- Industry conditions
- Historical valuation
- Competitor valuations
The best way to use the P/E ratio is as a starting point for deeper research, not as a standalone buy or sell signal.
Disclaimer:
This article is for general educational purposes only and does not constitute personalised investment advice. Stock-market investments are subject to market risks. Consider consulting a SEBI-registered investment adviser before making investment decisions based on your individual financial situation.
