FAQs on PE ratios

1)      What is a PE ratio and what are the different types of PE ratios?  

A PE ratio or price-to-earnings multiple for a company is one of the most popular measures used to select a company while investing. It is estimated by dividing the current market price of a company’s share by the company’s 12-month earnings per share. When the price of the share is divided by the last 12-month earnings per share (EPS), it is called trailing PE. On the other hand, when the price of the share is divided by the estimated next 12-month earnings per share (EPS), it is called the forward PE ratio. 

2)      Can one invest based on a PE ratio? 

There is a considerable misuse of the PE ratio while investing. A low PE ratio may not mean that the stock is cheap. Similarly, a high PE ratio does not mean that the particular stock is expensive. The market’s overall PE ratio, on the other hand, can be better used to evaluate whether stocks are worth investing in. For example, when the trailing PE ratio for the stock market is high, the equity market may become dependent on the future earnings growth (as we are currently experiencing) and a forward PE ratio may be used to evaluate the market for investments.  

3)      What about individual company or sector PE ratios?  

When it comes to individual company PE ratios, there can be considerable differences in PE ratios based on the growth characteristics of each company. For example, a high-growth company may have a higher PE ratio because its earnings may grow faster than the overall sector in the long-term, supporting its high valuation. An example of a high growth company in India is Dixon Technologies, which has a PE ratio of 150x as it has grown its earnings per share at close to 30 per cent YoY and is likely to experience an acceleration in growth, driven by the recent PLI announcements. Similarly, sectors that have higher long-term growth prospects have higher PE ratios e.g., the IT sector.  

4)      Why do some sectors have high PE ratios despite recent poor performance? 

Some sectors/companies have high PE ratios as they report negligible profits while in some cases, they tend to register losses due to an adverse economic scenario. For example, Tata Steel does not have a positive value as its PE ratio since it has reported a loss over the last 12 months. Cyclical companies tend to have high PE ratios at the start of their industry cycle and low PE ratios at the end of their cycle as profits are low at the start and high at the end. In such cases, an investor would need to evaluate the PE ratio adjusted for the industry cycle.  

5)      To summarise, what are the factors that impact the PE ratio? 

Apart from the growth in earnings, the factors which impact PE ratio include: 

a) Earnings stability: A more stable earnings profile would support a higher PE ratio.

b) Dividends: Dividends are a sign that a company is confident of achieving growth in the long-term. Higher dividend payouts (percentage of earnings that are paid as dividends) would lead to higher PE ratios. 

c) Return on invested capital (ROIC): A higher ROIC would indicate higher long-term growth. 

d) Interest rates: As all cash earnings are discounted at relevant interest rates, lower interest rates would support higher PE ratios.