What is PE ratio | Price Earning Ratio (ttm) in stock market ?

PE RATIO is known as price to earnings ratio. It is the measure of share price in relation to net income earned by the firm per share (EPS).In simple words, it is ratio of company's share price to company's earnings per share. It is used in valuing companies and to determine whether the share price is undervalued or overvalued.

It is given by a simple formula :

P/E RATIO =PRICE PER SHARE/EPS 

Let us consider an example :

Market price of a company A is 180rs and EPS is 10 then pe is 180/10= 18

So it comes out to be 18. It means that in the last trade that was carried out, investors were ready to pay 18 times the earnings of company A. It's not very easy to conclude that a stock with pe 10 is cheaper as compared to a stock with pe 50 is expensive.

PE RATIO are of two types:

--) Trailing pe ratio:The pe ratio that is evaluated on the basis of last 12 months of  actual earnings. It is calculated by dividing current market price by trailing EPS of last 12 months. 

--) Future pe ratio: The pe ratio that is evaluated on the basis of future earnings of the company. It is calculated by dividing current market price by estimated earnings per share(EPS).

UNDERSTANDING PE RATIO 

Let is consider following situations :

Company A

Such types of companies are called low pe-low growth companies. In this example the average growth of company is 10% annually. Such companies give an average return on investment.

Company B

Such types of companies are known as high pe-high growth companies. In this example the average growth of company is 100% annually. Such companies give huge returns and such stocks are known as multibaggers.

In the above examples let us assume that both the companies A and B are of same sector and  let the industry pe be 11.5. It seems that company A is cheaper as compared to company B but we know that stock B is multibagger and a better option than stock A. This shows that pe ratio may differ in respective cases. It may be good if high or low with respect to growth of company.

Company C

Such type of companies are called 

low pe-negative growth companies. In this example the average growth of company is -20% annually. Such companies give negative returns on investment .It means that people make loss in their investment.

Company D

Such types of companies/industries are called cylindrical Industries. For example: construction and realty industry and company grows with rapid rate when they get projects or big contracts there is fast growth but after 1-2 years the share price follows rapid down trend. These sectors follow a circular path therefore they are termed as cylindrical Industries.

REASONS FOR HIGH PE 

--) Stock might be overvalued.

(Stock may be overvalued due to large numbers of investors buying a particular stock. Since demand more and supply less,hence the stock price increases.)

--) Future of the company might be bright and the company's high growth rate are the main reason for high pe.

REASONS FOR LOW PE 

--) Stock might be undervalued.

(Stock may be undervalued under circumstances of near recession,any govt. scheme unfavourable for company,or when market is fearful.)

--) Company might observe negative or steap decline in growth and the future prospects of the company might not be appreciable. 

CORRECT WAY TO CHECK PE 

Correct way to check pe is to compare its pe with peer companies/industries or comparing directly with industry pe. It is very important to know why pe is high or low. Most of the reasons are mentioned above. It is also important to know that the growth of company is sustainable or temporary,as growth is one of the deciding factors in increasing share price of any company.