i.e. P/E = (Stock Price) / (Earnings per Share)

*is generally available with the company's financial information. Simply stating EPS is calculated by dividing the earnings (net profit) by the total number of equity shares. Thus, if XYZ has 2 crore shares and has earned Rs 4 crore in the past 12 months, it has an EPS of Rs 2.*

**Earnings per Share**Now to calculate earnings per share you can use last years earnings or next years estimated earnings. Using these you get 2 ratios

*(using last years earnings)*

**backward P/E ratio***(using estimated earnings). People generally prefer forward P/E ratio.*

**forward P/E ratio**The P/E ratio takes the stock price and divides it by the last years earnings. If XYZ is currently trading at Rs. 20 a share with Rs. 4 of earnings per share (EPS), it would have a P/E of 5. Big increase in earnings is an important factor for share value appreciation. When a stock's P-E ratio is high, the majority of investors consider it as pricey or overvalued.

**Stocks with low P-E's are typically considered a good value**. However, studies done and past market experience have proved that the higher the P/E, the better the stock.

A Company that currently earns Re 1 per share and expects its earnings to grow at 20% p.a will sell at some multiple of its future earnings. Assuming that earnings will be Rs 2.50 (i.e Re 1 compounded at 20% p.a for 5 years). Also assume that the normal P/E ratio is 15. Then the stock selling at a normal P/E ratio of 15 times of the expected earnings of Rs 2.50 could sell for Rs 37.50 (i.e rs 2.5*15) or 37.5 times of this years earnings.

**Thus if a company expects its earnings to grow by 20% per year in the future, investors will be willing to pay now for those shares an amount based on those future earnings**.

In this buying frenzy, the investors would bid the price up until a share sells at a very high P/E ratio relative to its present earnings. First, one can obtain some idea of a reasonable price to pay for the stock by comparing its present P/E to its past levels of P/E ratio. One can learn what is a high and what is a low P/E for the individual company. One can compare the P/E ratio of the company with that of the market giving a relative measure. One can also use the average P/E ratio over time to help judge the reasonableness of the present levels of prices. All this suggests that as an investor one has to attempt to purchase a stock close to what is judged as a reasonable P/E ratio based on the comparisons made. One must also realize that we must pay a higher price for a quality company with quality management and attractive earnings potential.

The above point will be discussed in detail when we discuss

**PEG ratio**.

Another important factor to keep in mind is that P/E by itself would only tell you half the story. You need to compare the P/E of a stock with its competitors to get a fair idea how that sector is being rated.

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