Price-to-earnings ratio or the P/E ratio can help spot valuable stocks across the industry sectors and evaluate whether a particular stock is undervalued or overvalued.
How To Calculate P/E Ratio
The P/E ratio can be calculated by dividing the share price by earnings per share (EPS), and to determine EPS, subtract the company's total dividend paid from its net income and divide it by its total shares.
Suppose a company has paid shareholders Rs 100 crore in dividends, with a net income of Rs 400 crore and the total number of shares at 100,000,000; the EPS will be 30. And if the share price is Rs 100, the P/E ratio will be 3.3. You can find a value stock by comparing the P/E ratios of the highest market cap stocks.
Types of P/E Ratios
Forward P/E: Forward or leading P/E ratio considers the company's future earnings guidance instead of trailing numbers. It is useful in comparing current and future earnings and provides a clearer view.
Trailing P/E
Trailing P/E ratio or Trailing 12 months (TTM) P/E ratio is investors' most commonly used performance indicator, which considers the company's past earnings. Thus, it enables a more precise assessment of a company's performance. The Forward and TTM P/E ratios are also called Absolute P/E ratios.
Relative P/E Ratio
To calculate the relative P/E ratio, compare the absolute P/E ratio to a range of P/E ratios for a particular period, say, ten years. The Current PE value is typically compared to the highest value in the range. For example, if a stock's highest PE ratio in 10 years was 20 and it is currently selling at a PE of 8, its relative PE will be 2.5.
Things To Remember
Finally, P/E ratios are only one of the tools to determine if a stock is overvalued or undervalued. Sometimes, a high P/E ratio could also mean the stock's higher growth potential, as it shows the investors' willingness to pay a higher price for the stock, betting on its positive growth prospects. Also, always compare the P/E ratio of companies in the same sector.
