To determine the price to earnings ratio or P/E, one has to first arrive at the EPS. EPS is nothing but the net profit of a company divided by the outstanding shares.
For example, if a company has 4 crore outstanding shares and its net profit is Rs 4 crores, then the EPS is Rs 1.
Formula for EPS: Net profits/Outstanding shares
Why is the price to earnings ratio important?
The price to earnings ratio is an extremely significant ratio and tells you whether a stock is overvalued or undervalued.
For example, if company A has a price to earnings ratio of 15 and company B has a price to earnings ratio of 7, then we could argue that company B is more attractively valued than company A.
However, the price to earnings ratio should be considered along with other parameters. Say for example company A and B are from different industries, then it would not be fair to compare the price to earnings ratio. For example in India, FMCG companies are always accorded a higher price to earnings ratio, as compared to the metal companies.
Even if there are two companies from the same industry, there would be other parameters also to look at along with the price to earnings ratio. These would include future growth prospects, price to book value, return on networth etc. Some stocks are accorded higher price to earnings ratio considering the stability of the industry, future prospects etc. Also, one does tend to look at the dividend yields, management integrity etc. For example, Titan, a Tata Group company is accorded a very high price to earnings multiple because of its management integrity, recession proof business, future prospects etc.