Valuing Stocks with P/E ratio

Valuing stocks has many facets when it comes to evaluating the stocks. The evaluation of stocks
involves estimating the true value of stocks in order to formulate the investment strategy. The
most commonly heard term pertaining to valuation of stocks is P/E ratio. P/E ratio is one of the
oldest and frequently used tools in valuation of stocks. However, P/E ratio may seem to be
simple in terms of calculation, the ratio is actually difficult to interpret. It may provide valuable
insights regarding stock valuation, but at times may prove to be useless. P/E ratio is an indicator
of the price an investor is willing to pay for per unit of earning.

P/E ratio is the ratio of a price of the stock to its per-share earnings. Hence P/E ratio is
calculated as follows:

P/E ratio = Market value of the stock

Earnings per share

P/E ratio is sometimes calculated using earnings per share from the last four quarters. The P/E
ratio thus calculated is known as trailing P/E ratio. Conversely, if the earning per share used is
based on estimated earnings, it is known as leading P/E ratio. However, the difference between
two types of P/E ratios is mainly of actual historical data and future estimates which are more
susceptible to errors.

Applications of P/E ratio:

1. Estimating the growth: Generally, P/E ratio is based on the historical data of company’s
earnings, but it also takes into account the market expectations for the company’s
growth. Thus, a higher P/E ratio of a company in comparison to the industry average
indicates towards higher expectations of market from the company. If the company
fails to deliver expected results in accordance with market expectations, the stock prices
may drop in near future.
2. Valuation of the stock: P/E ratio is comparatively a better indicator of the value of stock
than market. However, it is difficult to interpret true valuation of a stock without
considering the growth rate of a company and the industry characteristics to which a
company belongs to.
Limitations of P/E ratio:

1. P/E ratio includes earnings which also includes non-cash items. Also, the variability in
adoption of accounting principles makes things more complicated. For, example a
company using generally accepted principles would have different implications over
earnings in comparison to the company using a completely different set of accounting
principles.
2. The P/E ratio may seem distorted in high inflation times due to the rise in replacement
costs of goods and equipments. Generally, P/E ratios are at lower side in high inflation
times primarily because of the above stated reason.
3. A company having a low P/E ratio does not always indicate undervaluation. A low P/E
may also indicates that company earnings would be lower than expected. A trailing P/E
ratio fails to recognize this until the actual earning figures are taking into account. This
limitation may cause a company to look fairly undervalued.
4. A company which is not profitable and posses negative earnings per share may pose
problems in correct interpretation of the P/E ratio. The opinions may vary accordingly
interpreting the P/E ratio to be negative, zero or non-existence of a P/E ratio.