P/E or price to earnings ratio is an important metric that helps in adjudging valuation of the stock. Simply, speaking it is reflective of the price the investor or market as a whole is willing to pay today as against the company's future or past earnings. With the P/E measure in hand, the stock can be understood with respect to its valuation i.e. whether it is undervalued or over-valued. At the same time, it pays to compare a given stock's valuation with other stocks from the same space.
Say, for instance, a P/E of 20 times highlights that in the expectation of earning Rs. 1, the market is ready to pay Rs. 20. It is to be noted, that price is not reflective of the absolute earnings and only is an expectation on annual earnings growth of the company.
A high PE signifies expectations of high earnings growth over the coming year and vice-versa.
Metric highly useful for value stock pickers
Value investing is based on the notion that market reacts to positives and negatives; and in many a case, the stock price movement in many a scrip do not match with its long term's fundamentals. So, value stock pickers take positions in such stock in the assumption that current deflated price shall be the most reasonable bet for the stock as they see the stock to be undervalued by the market.
For the same industry, the undervalued stock or stock with a low P/E will be available at a lesser cost per share for almost similar financial performance than one with a higher P/E.
Historical or Trailing P/E vs forward P/E
P/E metric that helps to assess valuation is further classified as historical or trailing PE and the other forward PE.
Historical or trailing PE is arrived at by taking into account past 12 months' earnings whereas the forward PE is just an outlook based on estimated one-year earnings for the year going forward. The corporate announcement or any such external factor makes the very nature of forward PE as dynamic. It is to be noted that for picking a stock both the forward and trailing PE are used alongside.
Importance of PE ratio
Solely, the measure serves no use and hence has to be used in connection with historical PE, portfolio PE etc to reach a prudent conclusion. The portfolio PE likewise is the weighted average PE of all stocks put together. Similarly, market index also is made by a portfolio of stocks and its P/E is computed as the index price divided by total earnings from individual stocks.
Limitation of P/E ratio
Earnings of the company are either historical or forward that are based on the analysts' opinion. So, consequently, it is difficult to estimate company's earnings since past earnings do not ensure future earnings and at the same time, the analyst estimates can be wrong. Interestingly, the ratio also does not take into account the possible earnings growth scenario.