Home Fundamental analysis What is PE ratio

What is PE ratio


What is PE ratio in stock market ?

Knowing What is Price Earnings Ratio

Many of us playing in the stock market and the financial market are eager to invest and trade in shares. However, the majority of us are not quite sure how, to begin with investing in stocks and construct our stock portfolio. Share market is an interesting subject and we must put inadequate efforts to understand the secrets of investing. We can either be a trader or investor according to an individual’s choice and our own temperament. To attain our long-term goals driven objectives, we can invest in chosen equities. What we need a DEMAT account along with a trading account with a broker to start investing in stocks

Why companies sell their shares?

To meet the need for capital, companies issue shares to the public. Interested persons in investing in the company can buy shares in the primary market through IPO which is a short form of an initial public offer. Then the company coming up with IPO gets listed on the stock exchanges. The shares you bought can be traded in the open market through exchanges where the company is listed, called the secondary market. Based on market capitalization (a product of traded price and a total number of shares), companies can be termed as large-cap, mid-cap, or small-cap.

How to select a stock?

Selecting stock is a matter of knowledge and skill to analyze the share and is an especially important and crucial step involving research either fundamentally or technically or may be both. Fundamental analysis and technical analysis are two popular and widely used methods to find a share where possibilities of profits may exist.


Importance of Fundamental and Technical Analyses:

Fundamental analysis lets you identify a good company and technical analysis paves the way when buying and selling the stock. Technical analysis is an approach to analyze the price charts of shares based on actual traded data based on 6 doctrines of Charles Dow who as founder editor of Wall Street Journal had written 255 articles based on his detailed studies on price movements and behavior of price action in the stock market.

What is a price to earnings ratio in a stock market?

Before investing in shares, careful study of the company is a very important step as investing in the stock market could otherwise be very risky. Learning to analyze the stock market and stocks can be learned. Any investor should know what is PE ratio and EPS. EPS stands for Earnings Per Share and is calculated as illustrated below:

EPS = Net Income- Preferred Dividends / Number of outstanding shares

A company with high EPS indicates that it is a profitable entity, and therefore it is capable to distribute profits so earned through its business to Company’s shareholders. Now, let us understand what the PE ratio is. It is a ratio of the traded price of share and EPS and hence referred to as price to earnings ratio

PE ratio = traded price of share / EPS

Importance of PE ratio

Before we understand the importance of PE ratio, let me tell you that there are two types of PE ratios that are calculated. One is based on trailing 12 months EPS and is called PE TTM and another is based on estimated earnings of the company which is forecast and is known as forwarding PE ratio or FPE. PE ratio tells us about the growth potential of a company. High PE implies that investors are optimistic about the performance and future earnings of the company and hence investors are willing to pay a higher price. It also indicates that the stock is overvalued. Basically, the PE ratio is a function of traded price and earnings and hence if the stock price corrects or retraces, PE will go lower, and it may go lower of earnings of the company increase.

Companies with a high PE ratio are known as growth stocks. Investors, therefore, perceive that these stocks will do well in the future and so are willing to pay more price for these stocks. As these stocks are overvalued because of higher traded price, which is not justified by earnings, they are associated with high risk with less favorable risk to reward ratio. In contrast, Companies with low PE ratios are considered to be value stocks.

PE ratio should not be the only criterion for stock selection in the stock market, but there are several other factors that should be considered before investing in shares. Yes, the PE ratio of a Company can be compared with similar companies in the same sector or industry under similar socio-economic conditions in which they operate.

You may also like