Price to Earnings (P/E Ratio)

 Price to Earnings (P/E Ratio): Professor Gregory Mankiw, defines the Price-to-Earnings (P/E) ratio as a key metric for evaluating a company's valuation. The P/E ratio is calculated by dividing the market value per share by the earnings per share (EPS). 

    - This ratio indicates how much investors are willing to pay per dollar of earnings, helping to assess whether a stock is overvalued or undervalued relative to its earnings.

    - The P/E ratio is arguably the most widely used metric in investment decisions and comparisons across companies.

• A high P/E ratio suggests either the stock is overvalued or investors expect high future growth of the company.
• A low P/E ratio indicates either the stock is undervalued or that the company is facing challenges in terms of growth.

Keep in Mind: Determining what constitutes a high or low P/E ratio is perhaps the most challenging aspect of using this metric:

• It depends on the stage of the company's life cycle. A company in its growth phase can demand higher P/E compared to its peers which are in mature phase or in declining phase.
• It depends on the industry to which the company belongs. A non-cyclical company typically commands a higher P/E ratio compared to a cyclical company. (Non-cyclical company can be a FMCG company and cyclical company can be any infrastructure company)

Formula:

    P/E Ratio = Price per Share / Earnings per Share

Interpretation:

•     When a company is operating at a loss, its earnings per share will be negative, hence the P/E ratio will also be negative, making the P/E ratio misleading in those situations. Thus, the P/E ratio typically provides valuable insights for any profitable company.

•     The valuation of a company cannot be accurately judged by looking at the P/E ratio of the company alone. To gauge a company's valuation, its P/E ratio should be compared with that of the peer companies. If the P/E of the company is higher than that of its close peers, it is considered overvalued..

•     Another approach to judge whether a company is overvalued or undervalued can be to compare the current P/E with the historical average P/E. If the current P/E is lesser, it is undervalued. This approach is used when a company lacks suitable competitors for comparison.

P/E of an Index:

    To find out whether any stock index (like nifty, sensex or S&P 500) is overvalued or undervalued, we often look at the P/E multiple of the index as well. In these cases the current P/E gets compared with the historical average P/E and if current P/E is more than historical average P/E, the index is considered as overvalued and vice versa.

Note: Experts forecast the future value of an index using the P/E multiple of the index.