PE Ratio and Forex

The price earnings ratio is the ratio of the market price per share to the earnings per share i.e.

PE = Market Price per share
Earning per share

The earnings per share (EPS) is basically considered on the basis of net profit for the last four quarters. This is popularly known as the trailing P/E. When the EPS is based on the expected earnings for the next few quarters, then what one gets is known as the forward P/E. There is also a third variation that takes the in-between path, where the EPS for the last two quarters and forward earnings for the next two quarters are taken into account.

How can one use the P/E ratio?

The P/E of a company tells us how much investors are willing to pay, based on the earnings of the company. For this reason, the P/E ratio is also known as the P/E multiple of the stock.
For example, a P/E ratio of 25 suggests that investors are willing to pay Rs 25 for every Re 1 of earnings that the company generates.
Investors look at the P/E ratio as future market expectations of a company’s growth prospects in terms of profitability. If the P/E of a company is on the higher side when compared to its industry averages, it means the market is expecting some positive events from the company as far as earnings are concerned. Other way of looking at higher PE is that companies market value is higher and hence expensive.
Take, for example, the media sector in India. It’s a fairly new industry and many companies are showing accumulated losses in their balance sheets. Yet, the industry has a P/E ratio of close to 40. This shows that investors are confident of the prospects for this industry.
But a P/E is always like a double-edged sword. On the one hand, it is a great tool for comparisons. On the other hand, it can have completely opposite implications. For example, skeptics feel that a P/E multiple of 40 for the media industry is certainly not justifiable because these companies are yet to perform and have a long way to go when we look at their balance sheets. A P/E of 40, when compared to the P/E of the Sensex, appears very high and can be considered over-valued.
In fact, this ratio is very high when we compare it with the capital goods industry, which has a phenomenal growth rate and has a P/E of 25-30. For a lot of investors, this is a signal to probably get out of this sector.

What are the other parameters that need to be considered when looking at the P/E ratio?

To make sense of the P/E ratio, we need to look at growth rates and industry performance. When it comes to growth rates, probably the most fundamental question that is asked in the market is how fast a particular sector has been growing in the past, and are these growth rates sustainable? If they are not sustainable and yet the industry has a very high P/E, then one needs to evaluate their investment risks. Because a P/E ratio is synonymous with the future growth of the company, most analysts feel that it should be calculated by considering the forward earnings, rather than those based on the past.

On the other hand, P/Es should ideally be compared with companies belonging to the same industry, as broad factors affecting these companies do not change. For example, comparing a software company with a commodity business will not make sense, as industry dynamics are different.

Can the P/E ratio be considered the one important tool to make your investment decisions?

Experts have always advised investors not to take investment decisions based only on P/E ratios. Stock prices are affected by multiple factors. One must consider the P/E as an important ratio. But there are always more things to an investment than its P/E multiple and forward earnings and in many cases it could also be insufficient.