PE Ratio – Price to Earnings Ratio Meaning and Calculation

Have you ever looked at two companies with similar growth in the same industry and felt confused about which company's stock is better to invest in? That’s where the price-to-earnings ratio, or PE Ratio, comes in. In this article, we will uncover what is PE ratio and also understand its formula, advantages, limitations, and why it holds importance for investors.

What Is PE Ratio in Share Market?

The PE ratio, which stands for Price-to-Earnings ratio, is a valuation metric that compares a company’s current share price to its earnings per share (EPS). In simple terms, it shows how much investors are willing to pay today for every Re.1 of earnings the company generates. The ratio reflects market perception, future growth potential, and the risk profile of the company. Investors should consider industry trends, company fundamentals, and macroeconomic factors, which play a crucial role in their interpretation. 

PE Ratio Formula

The PE Ratio formula is simple; you just need to divide the current market price per share by its EPS (Earnings Per Share):

PE Ratio = Market Price per Share ÷ Earnings per Share (EPS)

Here,

Market Price of share = The price at which the stock is trading on the exchanges

Earnings per Share (EPS) = Net Profit of the company ÷ Its total outstanding shares.

Before diving into the PE ratio calculation, we have to understand that the EPS in the above formula will vary depending on the type of PE. So, let us first explore its types, Absolute PE and Relative PE, understand what constitutes an ideal PE ratio, and discuss its advantages, limitations, and other important considerations.

Types of PE Ratio

PE ratios are broadly classified into two types, depending on whether they use past earnings data or future earnings estimates for valuation. Here are the two types of PE ratio:

1) Trailing PE (TTM)

The trailing price-to-earnings ratio compares a company’s current share price to its earnings per share (EPS) over the past 12 months. This metric is based on a TTM (Trailing Twelve Months) basis where the data is sourced from the company’s financial statements for the latest consecutive twelve-month period, which may not align with the financial year-end. It uses historical data reflecting recent performance and events.

2) Forward PE

Forward PE uses estimated future earnings to value a company rather than trailing figures. Analysts predict these earnings per share for the next year. Investors divide the current stock price by this estimated future EPS. This allows them to assess what they are paying today for expected future profits. A lower Forward PE may suggest undervaluation. 

Absolute PE Vs Relative PE

1) Absolute PE

The PE ratios types (TTM or Forward) mentioned above can also be known as Absolute PE, which is a simple calculation of a stock's price divided by its earnings per share (EPS). It reflects how much investors are willing to pay for each rupee of earnings. 

This metric is commonly used, but it should be applied within industry benchmarks for proper comparison. For example, if a stock's current price is Rs. 100 and its trailing EPS is Rs. 2, the absolute PE ratio would be 50 (Rs. 100/Rs. 2). This helps evaluate whether a stock is overvalued or undervalued but does not consider historical or industry comparisons.

2) Relative PE

The Relative PE compares the current absolute PE ratio to historical PE ratios of the same stock or a benchmark, such as industry averages. For instance, if the current PE is lower than the historical average, it may indicate undervaluation due to industry downturns, changes in business models, or other factors. Conversely, if it exceeds past values, it may suggest overvaluation based on growth and earnings expectations.

What Is a Good PE Ratio?

The ideal PE ratio typically ranges from 20 to 25, but it must be evaluated in the context of the industry, economic conditions, and the company’s growth.

9 outlook. Different industries have distinct benchmarks; for instance, software companies typically have higher PE ratios due to rapid growth expectations, whereas traditional sectors like utilities have lower ratios due to slower growth. 

Thus, we cannot use a single PE value across all stocks to determine undervaluation or overvaluation. Instead of a single ideal PE, compare a company's PE to its industry peers and its own historical average, considering its growth prospects and market conditions.

Advantages of the PE Ratio

• Simple to Calculate: The PE ratio is easy to compute using publicly available data like stock price and earnings per share (EPS). The calculation simplicity makes it one of the most widely used valuation tools for analysis by Investors. 

• Helps Identify Potential Undervalued Stocks: Investors often use the PE ratio to spot stocks trading below their intrinsic value, providing potential buying opportunities.

• Reflects Market Sentiment and Expectations: A higher PE ratio often indicates positive market sentiment and expectations of future growth, while a lower PE may reflect negative sentiment or limited growth prospects.

• Facilitates Comparison within the Same Sector: The PE ratio is highly effective when comparing companies operating in the same industry or sector, where growth rates and business models are relatively similar.

• Useful for Screening Stocks: The PE ratio serves as a quick filtering tool for investors and analysts to shortlist stocks for deeper research based on valuation levels.

Limitations of the PE Ratio

• Does not account for Future Growth: A high PE ratio may be justified for companies with strong future growth, but the ratio alone does not factor in the earnings growth and may mislead investors.

• Ignores Debt: The ratio doesn’t consider the factors of the balance sheet, and therefore, the ratio, despite its lower or higher PE, it may not indicate the true value of the company.

• Not Applicable to Loss-Making Companies: The PE ratio becomes irrelevant for companies reporting negative earnings, as the formula fails in such scenarios.

• Industry Specific Variations: Different Industries have varying PE ranges. Comparing a tech firm with a utility company using PE may lead to wrong conclusions due to industry-specific dynamics and business model variations.

• Dependence on Historical Data (Trailing Earnings): Most PE ratios use past 12-month earnings, which may not reflect future potential. Relying solely on historical data can result in missed insights during shifting market conditions.

PE Ratio in Value Investing

The Price-to-Earnings ratio is a fundamental tool in value investing, guiding investors toward stocks that may be undervalued. By dividing a company's current share price by its earnings per share (EPS), the PE ratio reveals how much investors are willing to pay for each unit of earnings. A lower PE often suggests that a stock is trading below its intrinsic value, presenting potential opportunities for value investors to acquire shares at a discount. 

However, it's crucial to interpret the PE ratio within the context of the specific industry and market conditions. Different sectors naturally exhibit varying average PE ratios, and external factors like economic conditions can also influence these figures. Therefore, while the PE ratio is a valuable indicator, it should be considered alongside other financial metrics and qualitative factors to make well-informed investment decisions.

How to Calculate PE Ratio

Let’s take a real-world example to understand the calculation of the PE ratio:

Suppose:

Current Market Price of Infosys is Rs. 1,398 

Earnings per Share (EPS) (TTM) is Rs. 66.60

Apply the PE Ratio formula 

PE Ratio = Market Price per Share ÷ Earnings per Share (EPS)

Substitute the above values: 1,398/66.6 = 21 times.

What does the PE ratio indicate in this case?

This means that investors are willing to pay Rs. 21 for every Rs. 1 of Infosys earnings. Now, on a relative basis, we can compare this ratio with its nearest peer, which is involved in a similar business and industry, which is TCS. They have a Price to Earnings ratio of 24.3. 

When compared, Infosys has a lower PE compared to TCS. However, this does not mean that you invest in this stock directly. Along with the PE, one should analyze the earnings growth, the company’s business performance, service products, and other factors before making a decision. 

Note: The above information is based on 7th April 2025.

Alternatives to the PE Ratio

While the PE ratio is a go-to metric for many investors, it doesn’t capture all aspects of a company’s financial health; this is where the mentioned alternative valuation ratios come into play.

EV/EBITDA: 

The Enterprise Value to EBITDA (EV/EBITDA) ratio offers a broader perspective by including debt and excluding the effects of non-cash expenses like depreciation and amortization. While PE is useful for companies with consistent earnings, EV/EBITDA provides a clearer picture of overall business valuation, especially for firms with varying capital structures or heavy debt. Since EV accounts for both equity and debt, it neutralizes the effects of financing decisions, making it valuable to compare firms across sectors.

P/B Ratio: 

The Price-to-Book (P/B) ratio compares a company’s market price to its book value (i.e., net assets), offering insights into how the market values the company’s asset base. While the PE ratio focuses on profitability by comparing price to earnings, the P/B ratio highlights asset valuation. A low P/B ratio may indicate undervaluation or concerns about asset quality, whereas a high PE ratio might reflect strong earnings expectations or overvaluation. Conversely, a high P/B could signal market optimism, and a low PE might indicate earnings volatility. Together, these ratios provide a more comprehensive picture of a company’s performance, whether it is generating strong earnings or trading at a discount to its net worth.

PEG Ratio (PE to Growth): 

The PEG ratio refines the PE ratio by accounting for a company’s expected earnings growth. It’s calculated by dividing the PE ratio by the projected earnings growth rate, providing a dynamic view of valuation. For instance, a PEG of less than 1 could indicate that a stock is undervalued relative to its future growth, while a PEG above 1 might suggest overvaluation. This makes PEG especially useful for growth-oriented investors. However, its reliability is dependent on growth forecasts, which are often uncertain. Still, PEG remains a preferred tool for evaluating high-growth companies.

Conclusion

As we are at the end of the article, we have looked at the PE ratio’s meaning, its interpretation, importance, advantages and disadvantages, Relative comparison, and others. This metric is still widely used to understand the price of the company, and it continues to be the most looked-at metric in the world. However,  this metric alone should not be considered when making an investment decision; rather, it should be used in conjunction with the financials and other ratios.