Price Earning Ratio
Price Earning Ratio- (Current market price of share/Earnings per share)
It is the most widely used ratio by investors for analysing a stock. It represents the price at which the investor is willing to buy the shares of a company for every rupee of its earnings. Suppose, the P/E ratio is 10. This means the investor is willing to invest Rs 10 in the stocks for each rupee of its earnings. This ratio helps determine whether the stock is overvalued or undervalued. If the P/E ratio is high, this means the company’s share price is higher than its earnings which eventually indicates that the stock is overvalued. In this case, you should be aware of the value trap.
Similarly, the stock must be undervalued if the P/E ratio is lower than average. Investors see this as a golden opportunity and purchase such stocks at a price lower than its intrinsic value to earn profits when the stock price rises. While analysing the ratio, you should also keep in mind the average ratio of the company, current market conditions and the nature of the industry to which the company belongs. For instance, while assessing the ratio, check the ratios of other companies in the same industry. If a company has a P/E ratio of 50% and another company in the same industry has a P/E ratio of 20%, this probably means the latter is a more profitable company to invest in. But remember, this ratio should be used to compare different companies of the same industry and not companies across different sectors.