Why is Price to Earnings (P/E) Ratio important for Company Analysis?

P/E Ratio of a company determines the relationship between the individual current stock price of the company and the earnings of the company per share. Lower the P/E ratio, lesser the price has to be paid for a particular share with particular earnings per share. Conversely, lower the P/E ratio, higher will be the earnings per share for a specific share with a particular market price.

Often, when comparing the prices of two shares of separate companies, the profitability is considered to be higher when the price of a share is less than that of the other share. However, this is an incomplete picture and only one side of the coin. Whenever investors want to know about the current profitability (or future profitability, as the case may be of the share, they need to consider the earnings per share as well.

Formula & Example

Let us consider the example of stock ''X'.

For stock X, the market price is Rs. 100 and the earnings per share are Rs. 10.

Therefore, the Price to Earnings Ratio = 100/10 = 10.

Now, let us consider another example of stock ''Y'.

For stock Y, the market price is Rs. 100 and the earnings per share are Rs. 20.

Therefore, the Price to Earnings Ratio = 100/20 = 5.

Comparing the two cases, we see that though the prices of both the stocks are same, the price to earnings ratio is lower for stock Y. Thus, it can be concluded that the true profitability of a stock cannot be determined by taking into consideration only the price per share but also the earnings per share.

Let us consider the example of 'stock'.

For stock M, the market price is Rs. 100 and the earnings per share are Rs. 10.

Therefore, the Price to Earnings Ratio = 100/10 = 10.

Now, let us consider another example of stock ''N’.

For stock N, the market price is Rs. 120 and the earnings per share are Rs. 10.

Therefore, the Price to Earnings Ratio = 120/10 = 12.

Comparing the two cases, we see that, though the earnings per share of both the stocks are same, the price to earnings ratio is lower for stock M. Thus, it can be concluded that the true profitability of a stock cannot be determined by taking into consideration only the earnings per share but also the market price per share.

Limitations of Price to Earnings Ratio

• Fails to Show the True Picture during a Short-term Volatility: A temporary fall or rise in the earnings of the company due to some reason will completely distort the value of the P/E ratio which will pose to be misleading for the investors. For example, an insurance company got many claims in a particular year due to a flood, as a result of which the P/E ratio of the company rose drastically in that period. This will indicate a wrong message to the investors.
   
• Meaningful only when studied relatively: If a P/E ratio is studied individually, it makes no sense. For example, a P/E ratio of 10 is not very meaningful by itself. P/E ratio will be of actual use only when compared with the past performance of the firm or the past or present industry average.
   
• Ignores the Impact of Debt: P/E ratio focuses on market capitalization and price of the shares. By doing this, it becomes an inferior tool as compared to other measures such as Enterprise Value to EBITDA, etc. This is because the P/E ratio fails to take into consideration the impact of debt on the financial position of the company.
   
• Can be Manipulated easily: Since it takes into consideration earnings per share, the management of a company may manipulate the Ratio through the use of specific accounting techniques using the loopholes in the system.

Interpretation & Thumb Rule

Some of the conclusions that can be inferred through a comparative analysis of Price to Earnings Ratio are:

• High P/E Ratio: When the P/E ratio of the company is much higher than the industry average; for example, 30 when the industry average is only 12; then it might become risky (at least, in the short term) to invest in such a stock since the return on investment is quite low as compared to the other stocks. However, this situation is subject to a myriad of conditions.
   
• Low P/E Ratio: When the P/E ratio of the company is much lower than the industry average; for example, 8 when the industry average is 16; then it might become risky to invest in such a company.
  This is because the stock of such a company will be considered to be undervalued, the price of the stock will be relatively lower than the stocks of the like companies, and the company might not be expected to perform very well in future. Again, this situation is subject to a myriad of conditions.

There is no specific rule of thumb for a ratio like Price to Earnings. It is totally dependent on the industry in which the company is operating.

When is a high P/E Ratio Justified?

A growing trend in the Price to Earnings ratio of a company will indicate that the market value of the shares is also increasing simultaneously. This will lead to growth in the company. Investing in such a company will prove to be profitable for investors in the future. A high P/E ratio may indicate that the company will be performing well in the future, and the investors are ready to buy it for a higher price also.

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