What is PE Ratio?

The Price-to-Earnings (P/E) ratio is one of the most widely used tools for assessing stock valuation among investors. P/E ratio is also a crucial metric when a company goes public for IPO valuation. It is the ratio of the current price of a company’s share in relation to its earnings per share (EPS). 

It gives an indication about the valuation of a company's stock being undervalued or overvalued. It also serves as a comparative metric with industry benchmarks and peers. Also known as price multiple of earnings multiple.

What are the uses of P/E ratio?

• Serves as a valuation metric of stocks or shares to understand whether the stock is expensive or cheap.
• Helps in comparing a company’s valuation to its historical performance as well as with other companies in the same sector.
• Reflects the price investors are willing to pay for each unit of earnings, highlighting market expectations.
• IPO Valuations are primarily done using P/E multiple of the respective sector.

 

Typically, the P/E ratio considers a company’s current earnings from the past 12 months or during last one year. However, the ratio can also factor in projected earnings which is then known as the forward P/E. 

In essence, the P/E ratio reveals what the market is willing to pay today for a share of a company's earnings, be they historical or projected. It is a popular and widely accepted ratio that gives investors a better vision about the value of the company. The P/E ratio shows what the markets are expecting and how much investors must pay per unit of current earnings.

P/E ratio assist investors to understand the stock market and valuations of BSE and NSE listed companies enabling them to make strategic decision

 

How to calculate the P/E ratio (Price to Earnings ratio)?

Formula: 

P/E Ratio = Market value per share (MPS)
                       ​Earnings per share

 

The P/E ratio (Price-to-Earnings ratio) is calculated by dividing the current price of per share of a company by its earnings per share (EPS). 

 

For example, if a company has a P/E ratio of 30, it means that investors are willing to pay Rs 30 for every Rs 1 of earnings. 

In summary, the P/E ratio provides valuable insights into a company's current performance and helps investors make informed decisions.

 

Why is P/E Ratio important for investors?

• Provides better visibility of the stock- When investing in a company, it's important to understand both its current profits and future earnings. This is where the P/E ratio is helpful. Unlike the stock price, which tells you how much you pay for a share, the P/E ratio shows the earnings potential of a stock and its value over time. Trailing P/E is based on current/past earnings and forward P/E takes the projected earnings to assess the company’s performance.
• Widely used for stock valuation- Price-to-Earnings ratio metric is widely used and is universally accepted by the investment community and for valuation purposes by investment bankers, IPO advisors and consultants.
• Overvalued or undervalued stock- High P/E multiple might indicate that a stock is highly priced or overvalued as compared to its earnings and share prices may correct itself or fall in the near future. On the other hand, a low P/E multiple may indicate that a stock is underpriced or undervalued and its share price may rise in the near future.
• Crucial metric for Valuations- Merchant Bankers in India, IPO advisors and stock market analysts widely use P/E multiple to arrive at valuations. IPO valuations are done on the basis of PAT (profit after taxes and P/E multiple). Investors use the P/E ratio to see how a stock's price compares to its earnings, helping them make better investment choices.
• Comparative metric- The P/E ratio is a valuable tool for evaluating a company by analyzing its earnings history or comparing it with similar companies. P/E ratio facilitates peer comparison in the same sector and thus aids decision making amongst the investors in stock market.
• Value Investing- Value seeker investors are that category of investors who prefer to invest in low or undervalued stocks as their prices are low as compared to their earnings. Value investors are positive on such stocks and pick such stocks at lower prices and sell when the prices rise and get rewarded for risk undertaken. Value Investors generally invest with a long term horizon.

 

What role does P/E ratio play in IPO Valuation?

The P/E ratio plays a crucial role and it is one of the IPO valuation methods which helps investors and analysts determine a company's worth.

SME Merchant Bankers for IPO alongwith IPO Advisors play a crucial role in IPO valuations. IPO valuations are usually based on PAT (profit after taxes) of a company going public and P/E multiple applicable to a particular sector. P/E multiple is arrived at after considering various factors as highlighted below. 

 

It must be noted that the P/E multiple differs for every company even in the same sector depending on the nature of its business, management and growth prospects of a company

 

An ideal P/E ratio varies by industry, with average ratios typically ranging from 20 to 25. An average P/E is generally seen as favorable, while a very high P/E may indicate overvaluation. However, a high P/E can also reflect strong future expectations, which might justify the higher price. Analysts often calculate the forward P/E ratio using estimated earnings based on research and management input. This forward-looking perspective can provide insight into a company’s growth potential

 

For example, in a hypothetical scenario if two companies in the same industry have similar characteristics, and one has a P/E of 35 while the other has 29, investing in the company with a lower P/E (Company 2) may be more appealing. Thus, the P/E ratio is essential in assessing the attractiveness of a stock during an IPO

 

What role does IPO Advisors play in successful IPO?

IPO Advisors play an important role in successful launch of an IPO. Their advisory role from IPO readiness, selecting the best merchant banker in India for SME IPO, various due diligence activities and IPO valuation guides the company throughout the IPO Issue and listing process. IPO platform in India provides information on upcoming IPOs on NSE Emerge and BSE SME and list of merchant bankers and anchor investors. Role of IPO advisor is important in the success of the listings

 

How to determine the P/E ratio of IPO companies?

P/E Ratio plays a crucial role for SME IPO and mainboard IPOs. P/E multiple are often used to arrive at IPO valuations which in turn determines the IPO size for a company

 

Example

ABC Limited (tech company) is planning to go public and issue its shares through an IPO. How to determine the P/E ratio?

The P/E ratio is based on the average P/E ratio of other comparable companies in the same industry or sector affected by factors like the company's past performance, growth expectations, market conditions and others.

Average IPO Valuation

After reviewing similar companies in the same sector (e.g., tech sector), the industry P/E ratio is found to be around between 15 to 20.

• XYZ Tech Ltd. (a listed company) has a P/E ratio of 15.
• DEF Technologies (a listed company) has a P/E ratio of 20.
• AST Limited (a listed company) has a P/E ratio of 19. 

So, the average P/E ratio for the Tech company is 18 (Estimated)

If considered that the market is currently optimistic about the technology sector, so the underwriters may decide to price the stock closer to the higher end of the P/E range for the sector. So BRLMs may decide to value the company at average P/E multiple of 18. However, to be noted that valuations differ for each company basis their business model, financial performance, management and other factors

Check PE Ratio based on sector

 

How to determine the IPO Size and IPO Valuation?

IPO Valuation example in SME IPO

Continuing with the above example, ABC Limited that is preparing for its Initial Public Offering (IPO). Let’s understand How to calculate IPO size from the P/E multiple?

Related Information is given below for further calculation;

Profit and Loss Statement of the ABC Ltd
for the year ending 31 march XXXX

Particulars	Amount (in Rs)
Revenue	12,00,00,000
Expenses:
Cost of Goods Sold	(6,00,00,000)
Operating Expenses	(1,50,00,000)
EBIT (Earnings Before Interest and Taxes)	4,50,00,000
Interest Expenses	50,00,000
Tax Expenses	1,20,00,000
Profit After Tax (PAT)	2,80,00,000
Weighted Average Number of Shares	13,00,000
Earnings Per Share (EPS)	21.5

PAT for the last year is 2.80 crores and the projected PAT for next year is 5 crores (without funding)

 

How to determine IPO Valuation for company?

Company’s Valuation = Profit After Tax (PAT) * P/E Multiple

Company’s Valuation on the current profits = 2.8 * 18

Company’s Valuation = Rs 50.4 crores

For IPO purposes, Minimum dilution is 26.25% as mandated by SEBI. 25% is for outsiders and 1.25% is for market makers.

Hence in above IPO valuation example the IPO Size would be Rs 13.23 crores

However, if the company brings its IPO in the next year for which its projected earnings are Rs 5 crores than the IPO size would increase with increased PAT. If semi -annual or quarterly profits are used, PAT needs to be annualized accordingly for IPO size calculation purposes. Hence timing of the IPO also plays a significant role to maximize the IPO valuations.

 

Calculation of Company’s Valuation:

 

 

What is Earning Per Share (EPS)?

Earnings per share is essentially the portion of a company's profit allocated to each outstanding share. It represents how much money the company makes for each share if all profits were distributed to shareholders. 

 

EPS is a crucial indicator for traders, investors, and analysts, as it reflects a company's financial health. After all, no one wants to invest in a company that's losing money. This ratio is widely accepted in the investment community because it illustrates how much investors are willing to pay for a share of a company to earn a single unit of profit. 

 

What are the types of P/E Ratio?

Investors often consider two primary types of P/E ratios: the forward P/E ratio and the trailing (TTM) P/E ratio. Each serves a distinct purpose and is based on different timeframes of earnings. Let’s explore these ratios in detail.

 

1.Forward P/E Ratio:

The forward P/E ratio is calculated by dividing the current stock price by the company’s estimated future earnings. It’s also known as the estimated P/E. Forward P/E ratio is that type of P/E ratio that uses projected earnings or forecasts. Investors use the forward P/E to assess how well a company might do in the future. It’s a key tool for evaluating growth potential and offers future insights about the company. This ratio is relevant to rapidly growing sectors. However, the accuracy of earnings prediction could vary with unexpected changes in market conditions or company performance can significantly impact actual earnings

 

2.Trailing P/E Ratio:

The trailing P/E ratio looks at a company's earnings for the most recent 12-month period. This widely used metric gives a clear and realistic view of how the company has performed, using actual earnings instead of estimates. It uses the historical data making it less subject to forecasting errors. However, trailing P/E reflects the past performance and may not indicate the future growth. 

 

Also known as TTM P/E ratio. TTM stands for Trailing Twelve Months. It's a metric used in finance to indicate a company's performance over the previous 12 months

 

What is the Difference between Forward P/E Ratio and Trailing P/E Ratio?

 

Factors	Forward P/E	Trailing P/E
Time Frame	Looks at projected earnings for the next 12 months.	Looks at actual earnings from the past 12 months
Data Reliability	Based on estimates (can be uncertain).	Based on actual historical data (more reliable).
Growth Expectations	Reflects future growth expectations	Reflects past performance, doesn't account for future growth.
Market Context	This is more relevant for the rapidly growing companies.	This is more helpful for the stable industries.

 

Other P/E Ratios: 

 

Absolute and Relative P/E ratio

In addition to the forward and trailing P/E ratios, there are two other important types: the absolute P/E ratio and the relative P/E ratio. These help investors assess a company's value and performance

1.Absolute P/E Ratio:

The absolute P/E ratio is calculated by dividing the current stock price by either past or historical earnings. TTM P/E and the forward P/E are absolute P/E ratios. Major limitation of Absolute P/E ratio is that different sectors trade in different valuation ranges. For example- P/E ratio of tech companies is greater than the manufacturing companies but this does not mean that the manufacturing companies stock is cheaper than the tech stocks. This drawback of absolute P/E ratio is overcome by using relative P/E ratio.

2.Relative P/E Ratio:

The relative P/E ratio compares a company's absolute P/E ratio to a benchmark, like industry averages. This helps investors see how the company performs compared to its peers or the market. Relative P/E also compares the current absolute P/E to a benchmark or a range of past P/Es over a relevant time period, such as the last 10 years. Relative P/E shows what portion or percentage of the past P/Es the current P/E has reached.

For example, if a company's P/E over the last 10 years have ranged between 15 and 30. Now, if the current (absolute) P/E ratio is 25, the relative P/E comparing the current P/E to the highest value of this past range is 0.83 (25/30), and the current P/E relative to the low end of the range is 1.67 (25/15). This value indicates that the company's P/E is currently 83% of the 10-year high, and 67% higher than the 10-year low. 

 

What does high P/E ratio mean? And compare companies from P/E ratio?

When comparing companies using the P/E ratio, it's important to consider the industry average, as different sectors have different typical P/E ranges.

 

A company with a higher P/E ratio may be expected to grow faster than one with a lower P/E, but it could also be overvalued. Comparing trailing P/E (based on past earnings) with forward P/E (based on projected earnings) helps assess how much investors expect future growth. 

 

One shall keep in mind that always compare companies of similar types (growth vs. value stocks) and consider trends in their P/E ratios over time. 

 

Comparison of companies through P/E ratio also helps in determining the IPO size of an IPO bound company as understood above in the blog.

 

This approach gives a clearer picture of whether a stock is fairly valued, undervalued, or overvalued

 

What is a Good P/E /ideal P/E ratio?

 

Good P/E ratios can be differed by industry and market. There is no general rule about a good P/E ratio; what may seem to be a good or ideal P/E ratio in one sector could be not an ideal one for other sector. Also within the sector, companies have different P/E ratio due to various factors. 

 

This ratio captures the balance investors look for between the price they pay and the earnings a company generates, which is what attracts investors to a particular stock. A reasonable P/E ratio signals that a company's stock is fairly valued, making it more appealing to potential buyers.

 

In the Indian equity market, an average P/E ratio between 15 and 25 is often seen as attractive. This range may indicate a promising growth potential while also managing investment risk. By looking at the P/E ratio, investors can get a sense of whether a stock is fairly priced relative to its earnings. However, some growing companies have a P/E ratio of 75+ also.

 

It’s important to keep in mind that P/E ratios can vary from one sector to another, based on their unique growth rates and risk levels. Understanding these differences can help investors make good choices and better investment opportunities.

 

What is the meaning of Negative P/E ratio and Under what conditions does a company report a Negative P/E ratio?

A negative P/E ratio indicates that a company is currently reporting losses, meaning its expenses exceed its revenue. 

 

It might be the case that the company is investing heavily for future expansion, such as in research and development or market expansion, which can temporarily lead to negative earnings. 

 

Other factors, like changes in accounting methods, depreciation, or amortization policies, can also impact a company’s earnings in a given year and lead to a negative P/E ratio, even if the company is otherwise on a strong financial path.

 

However, if a company consistently shows a negative P/E ratio over a prolonged period—such as for several consecutive years—this should raise concerns for investors. It could indicate that the company is struggling to achieve profitability and may be in poor financial health. 

 

In case of negative P/E multiple, IPO valuation is done with EV/EBITDA multiple and QIB route IPO is possible on mainboard platform which limits retail participation to 10% and 75% quota is reserved for QIBs in loss making IPO company. For eg- Zomato IPO and Swiggy IPO

 

What are the limitations of P/E ratio?

While the P/E ratio can be a helpful tool for investors, it’s important to be aware of its limitations. Here are some key points to consider:

1.Managing the Earnings: The P/E ratio relies on earnings, which companies may manipulate to look better to investors. For instance, a company might use aggressive accounting methods to boost earnings or make one-time adjustments to show increased profits. This can make the P/E ratio misleading, leading investors to make poor choices.

2.Future Growth ignored: The P/E ratio only reflects current earnings and doesn’t take into account any company’s future growth potential. A high P/E might suggest overvaluation, but it could also indicate strong growth prospects. Conversely, a low P/E could signal undervaluation or weak growth potential.

3.Differ by Industry: P/E ratios vary widely by industry and sector. It is very complex to compare companies across different sectors. For example, technology firms typically have higher P/E ratios than utility companies due to their greater growth potential. Therefore, it's difficult to compare a company's P/E ratio with others in the same industry.

4.Market Trends and Volatility: Market volatility poses risks for investors since the P/E ratio, connected to stock prices and it can fluctuate with political, economic, and global events. While it’s a useful tool for assessing company value, it shouldn't be the only consideration for analyzing the mainboard IPO and SME IPO in India.

Recognizing its limitations highlights the need for a well-rounded strategy. Combining P/E insights with thorough market research can lead to smarter decisions and better navigation of market complexities.

 

Conclusion

 

The Price-to-Earnings (P/E) ratio is an indispensable tool for investors to evaluate the valuation of stocks and make informed decisions about whether a stock is undervalued or overvalued. It provides critical insights into how much investors are willing to pay for each unit of earnings, offering a snapshot of the market’s expectations for the company’s future growth potential. By calculating the P/E ratio, whether it's the trailing or forward P/E, investors can better gauge whether a company’s stock price reflects its earnings performance.

 

For IPO valuations, the P/E ratio plays a crucial role in determining a company’s market value and establishing a fair IPO size. Through comparative analysis with similar companies in the same sector, the P/E ratio assists analysts in assessing whether the stock is being priced optimally, helping both investors and companies to make sound decisions.