Price Earning Ratio-Check right price for share

Whenever you buy anything, you do always ensure that you are NOT paying exorbitant price for that. This is no different when you are investing for a stock. PE or “price earning ratio” ratio is one of the popular parameters among investors. Investors often compare the "price earning ratio" with that of another company with similar size and business.

The formula of "price earning ratio" is as given below

 

price earning ratio = Current Market Price/EPS

 

EPS is “earning per share”. EPS is calculated by dividing net profit by number of shares. There are two types of EPS, a) normal EPS and b) diluted EPS. Normal EPS considers only the regular stocks whereas the diluted EPS considers both normal and preference shares, stock options convertible bonds etc.  For the purpose of calculating "price earning ratio", always consider diluted EPS.

 

In theoretical terms, EPS signifies how much one share is earning and "price earning ratio" signifies how many years the stock will take to arrive the current market price (without considering growth rate, inflation etc).

 

Let us consider an example.

For 2012, the net profit of stock A is $ 8454.3 million. There are total 340.295 million of Shares for stock A.

 

So EPS = 8454.3/340.295=$ 24.84

 

The market price of A as on this date is $ 675

 

Hence "price earning ratio" = 675/24.84=27.17

 

Many people also use different "price earning ratio" term. When we use the EPS for the past period (last twelve months), it is called trailing "price earning ratio" and when we take estimate for future period, it is called forwarding "price earning ratio". Forwarding "price earning ratio" is the most popular with the analyst as they get a hunch that what will be the valuation of the stock going forward.

 

Now, the question is whether high "price earning ratio" bad and low "price earning ratio" good? Not really. Otherwise, it will be the only parameter, everyone would be checking and nothing else would be required.  It is observed that companies with good prospect and growth have high "price earning ratio" as people are willing to pay high price. Thus, when you check "price earning ratio", you do also compare the prospect of the companies. Many people also often use PEG, which is "price earning ratio"/Annual EPS growth. When the PEG is less than 0.5, the stock is considered to be available at cheap price and when it is more than 1, it is expansive.

Photo Courtesy Mikadiou