Price to Earnings (PE) Ratio – Its Types and Calculation

The PE ratio is a popular metric that investors use when choosing between stocks. This ratio helps determine whether a particular stock is undervalued or overvalued compared to its earnings. Keep reading to learn more about what is the PE ratio, how to calculate the PE ratio, and its different types.

What is the PE ratio in mutual funds?

PE ratio’s full form is the price-to-earnings ratio. It’s calculated by dividing a company’s share price by its earnings per share. This ratio helps investors see the relationship between a company’s stock price and its profits.

What is the PE ratio formula?

The formula of PE ratio is

PE Ratio = Market Price Per Share / (EPS) Earnings Per Share

Types of PE ratios

There are two types of PE ratios-

1. Trailing PE ratio

The trailing PE ratio is based on a company’s earnings over the past 12 months. It uses historical data to show how a company has performed, but it may not reflect future expectations. Since it looks at past results, the trailing PE ratio might not be suitable for companies experiencing rapid changes in their business.

2. Forward PE ratio

The forward PE ratio uses projected earnings for the next 12 months to give an idea of the company’s performance in the near future. While this can be useful, it relies on estimates that may not always be accurate, as future earnings are often uncertain.

Advantages of using the PE ratio

Here are a few reasons why mutual fund investors should use the PE ratio before investing-

1. Helps identify valuation

A high PE ratio might denote that the company is overvalued or on a growth trajectory. If the PE ratio is low, it indicates either the company is undervalued, or its performance is declining.

2. Useful for industry comparisons

The PE ratio is helpful when comparing companies in the same industry. For example, comparing the PE ratios of two companies in the tech sector can help identify which one might be a better investment opportunity.

3. Easy to calculate

The PE ratio is simple and easy to calculate and use. Investors just need the share price and the EPS to determine it. This simplicity makes it a popular choice for quick assessments of a stock’s valuation.

Limitations of the PE ratio

Although there are some benefits of the PE ratio, there are also some disadvantages-

- It doesn’t take a company’s debts or assets into account.

- It doesn’t provide information on the quality or stability of the company’s earnings.

- It can’t be used to compare companies across different industries.

- It doesn't give deep insights into the company’s cash flow.

Final thoughts

The PE ratio is a useful metric for assessing whether a stock is priced fairly in relation to its earnings. However, before making investment decisions, it’s important to consider other factors like a company’s growth potential, industry trends, and market conditions. 

If you’re planning to start your investment journey, choose Tata Capital Moneyfy. Here, you can easily compare different stocks and track your performance all in one place. Visit the Tata Capital Moneyfy website or download the app today!