It is no brainer that Profit earn by the company plays key role in valuation of the company. In that way, Profit per share or EPS is important. But one another ratio which is important here is P/E ratio or Price to earning ratio whis tell you how much investors are ready to pay for the company. The calculation behind it is
MARKET PRICE = EPS * PE
Importance of the Ratio is it is simplest ratio to understand. If you know what ia Profit and what is market Price then its easy to calculate.
But that is not all. This Ratio tells us many other things about the company.
- Make inverse the formula and you will get the Earning yield which tell you what is the expected rate with you Earn. It makes easy to compare with RFR. Risk free rate when you invest in Generally Govt securities. While writing this post, in India it is nearly 7%. Then you need to ean more on the investment as you are investing in Equity. So add the Equity Risk premium. For India it is nearly 8%. Minimum return from any investment in India is supposed to 15%.
- Just like stocks, index which is made up of the Stock, also has the PE and EPS. By comparing with that, active investor who is investing in specific stock may find out which is right opportunity to Invest.
- Most important. When some stock is showing say 15 PE, it mean market is assuming that the company will grow with 15% in that year that is in next four quarters. If company come with Good results, then it is seen as good sign.
- There are some variation about the Ratio. Is there is no mentioned then it is trailing PE. That is depending upon past four quarters earning. There is more type that is calculated depending upon future calculation. Say what will be the earning for future 4 quarter. Another one is Taking 2 past quarter and 2 Future expected.
- Just like market PE and stock PE, there is industry PE also. By comparing industry PE with stock PE, you can tell which stock are growing better and which are laggard. Generally fast growers received high PE and Stalwart or slow growing companies receive low.
Even though there are some limitations like difference in accounting, PE ratio is very helpful
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