Why is Price to Earnings or P/E Ratio important?

Financial ratios can be defined as the mathematical method which helps the people to learn about a company’s profitability, solvency, efficiency, liquidity, coverage, and market value. It also enables the people to gather insights about the company and understand its financial standing and valuation. It also provides vital guidance to stakeholders who must make financial choices for the company as well as external stakeholders, such as investors, who need to assess the company’s financial performance. 

Some of the most basic financial ratios are- Price to earnings ratio, Working Capital ratio, quick ratio, Return on equity ratio, debt to equity ratio, etc. These ratios play and important role in analysis of the statements like Cash flow statement, income statement, balance sheet, etc. 

Price to earnings ratio or P/E ratio is a proportion which is utilized to discover out the esteem of the company, whether it is exaggerated or underestimated. Speculators and investigators utilize the PE proportion to decide a company’s relative sum of offers for the company-to-company comparison, or it can to be utilized for the company to track its claim development. This not just helps in singular evaluation of a company or a stock but it can be done collectively on stock indexes like Nifty and Sensex

When it comes to evaluation, the greater PE proportion shows that the company is exaggerated, or the financial specialists are anticipating high development rates within the future and vice versa. 

The formula for calculating the P/E ratio is:

Types of P/E ratios:


  1. Forward price-to-earnings:

The forward P/E ratio is a forward-looking statistic that helps offer a better understanding of what revenues will seem like without modifications and other money decorating. This might be beneficial to investors since it gives them a sense of how future earnings would compare to current quarter earnings and historical earnings. It can also assist in forecasting the asset’s long-term profits. 

  1. Trailing price-to-earnings: 

Using a company’s profits over the previous 12 months is one approach to compute the P/E ratio. The trailing P/E ratio, or trailing twelve-month earnings, is used to calculate this. It is one of the most used because of it being objective in nature. It helps the users to understand the earnings of the companies perfectly. It helps the people to be assure about their calculations and that it is associated advantage. 

As everything is associated with pros and cons- the cons with it is that it predicts the future using the past performances which is not really a good idea and the earnings can only be updated quarterly is a major drawback. 

Limitations of P/E ratios:

One singe ratio cannot solve and let the investors know about all the details which are required to be known by them. So, considering this as every element is associated with pros and cons, this also has some very serious limitations which are important to be known by its users well. 

Some of the limitations being:

  • Not every company can use this tool as the company which are presently not profitable or showing to have negative earnings, this tool does not work for them. 
  • The timelines and the sectors can be different as so the expected P/E related to it can also be different. This can become a serious drawback when any P/E ratio is compared and should be kept in mind for proper functioning and understanding. 
  • It does not make sense to analyse the company by merely checking only its P/E ratio as there are various other factors associated with it. 
  • Stock prices fluctuate everyday but the earnings are released quarterly making it as one of the limitations of the P/E ratio. 

Difference between absolute and relative P/E ratio:

  • Absolute P/E ratio:

It is the basic P/E ratio calculation which has the formula of Market value per share divided by earning per share. 

  • Relative P/E ratio:

The supreme proportion of a firm is assessed against a benchmark P/E proportion or the past Cost to Profit of diverse companies within the computation of relative P/E ratios. Investors utilize it to evaluate how well a firm is performing in comparison to its past proportions or benchmark proportions.

ConclusionP/E ratio is quite credible but it cannot assure solely anything for the company or collective stocks. It is also one of the most basic Financial ratio used by people but it is essential for them to know both the advantages, disadvantages and all the other details associated with it.

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