The relationship between the market price of a company’s equity share and its profit per share is called the Price to Earnings Ratio (PE). PE ratio is an indication of whether or not the price of the share is reasonable in comparison with the PE ratios of its peers in the industry/sector. Generally, when the PE ratio is comparatively lower, the share is regarded by investors as a good pick for investment. Investor sentiment is vice-versa when the PE ratio is comparatively higher.
Calculation of Price to Earnings Ratio PE Ratio
The formula for computation of the PE ratio is
PE ratio = Market price of the share ÷ Earnings per share
Earnings per share (EPS) is calculated with the formula
Earnings per share(EPS) = Net profit ÷ Weighted average number of equity shares
When the PE ratio is calculated using the EPS for the preceding 4 quarters, it is called the ‘trailing PE ratio’
When it is computed using the EPS for the succeeding 4 quarters it is known as the ‘forward PE ratio’
Interpretation
The trailing ratio is based on actual performance of the company. The forward ratio is based on expected performance of the company. The ratio should be compared with that for peer companies and the industry / sector as a whole.
A high ratio could be market expectation that the company’s future performance will be substantially better or the stock may be overpriced. The converse would be true in case of a low ratio
Price per earning ratio or the PE is the market price of the company’s share to its profit per share. It indicates the pricing of the share to the other share and provides a basis for comparison. The article has a lot of new words which is a bit confusing.