What is Price to Earnings Ratio (PE Ratio)?
Price to Earnings Ratio or the PE Ratio measures the price that the market is eager to pay for the earnings of a company. It is computed as:
Market price per share/Earnings per share
PE can be said as a multiple of per rupee of earnings. When one refers to a stock trading at PE multiple of 12x, it indicates the stock is trading at twelve times its earnings.
Limited values of historical earnings for PE multiple. The prices alter with dynamism, while the reported earning is restructured every quarter. Consequently, prices tend to move even after the historical earning per share is addressed, in hope of the future earnings.
When it is expected that earnings of a firm will grow, then the market will be keen to pay a higher multiple per rupee of earning.
The aim is, as a result, on ‘prospective’ PE or how much the current price is discounting the future earnings.
For instance, when analysts say that shares of XYZ company is trading at 20 times its 2014 earnings, but is still about 15 times the 2015 earnings, given the state of its order book.
This means the growth in EPS islikely to be high, and for that reason the current high PE based on historical numbers may not be the right one.
Generally periodicals and news reveal the PE using historical earning numbers from the latest quarterly reports.
Analysts’ calculate approximately of future earnings are not extensively available and they may vary. Some publications report ‘consensus’ view of potential earnings.
It is general to look at the PE multiple of the index to measure if the market is overvalued or undervalued.
The PE multiple moves high when prices run ahead of the earnings numbers and the market is enthusiastic to pay more and more per rupee of earnings.
When markets correct and indecision about future earnings increases, the PE multiple also falls.
A value investor, who would like to pick up stocks when they are inexpensive, may be interested to purchase when PE is low.
To check the relative value, the analyst also compares the PE of one company with another company.
The PE multiple of a stable, large and well-known company is likely to be higher than the PE multiple the market is keen to pay for another smaller, less known, and unsafe company in the same sector.
What is Price-to-Sales Ratio (P/S)?
Price to Sales ratio is a valuation ratio that measures the price investors are enthusiastic to pay for each rupee of sales.
It is calculated as:
Price to share Ratio (P/S Ratio) = (CMP)Current Market Price / Annual Net Sales per Share (Or) P/S Ratio = Market capitalization / Annual Net Sales
For instance, a company with annual net sales of 2 Crores, outstanding shares of 20 Lakh and CMP of Rs. 40, P/S Ratio would be
Annual Net Sales per Share = 2 crore / 20 lakhs = 10
P/S Ratio = 40 / 10 = 4
A low P/S ratio may indicate an undervalued stock, and if it is paired with a trend of sturdy increasing sales then it may be astriking investment proposition.
While a high P/S ratio points out a highly priced stock, it may also point out an expectation of high future growth rate in sales and consequently the market’s willingness to pay a high price for it.
A fall in the revenue growth rate will be a high risk for these stocks. Similar to other multiples, the P/S ratio should be used along with other data and compared with similar companies in the industry before making an investment decision.