Price to earnings (PE) ratio measures the relationship between earnings and price of a company. In general terms, for every one-rupee earnings how much you want to pay to buy a stock.
Example,
Company A is trading at Rs 100 and Company B is trading at RS 50, looking at the price company A is expensive.
Company A earning per share (EPS) is 11 and Company B EPS is 10, looking at EPS company A has high EPS.
Let’s look PE ratio of both: Company A, 100/11 = 9 and Company B 50/10 = 5
Though Company A has high EPS and price, Company B is trading at 45% cheaper compared to Company A.
Company with negative earnings will have 0 PE and few times companies may report a very high or low PE because of abnormal earnings due exceptional gains/losses, unexpected events etc.
Comparing PE with its peers having a similar business or with its historical P/E gives more prospective of a stock valuation. Generally, mid and small cap companies will trade at higher PE multiple due high EPS growth rates and future expectation.
How does high PE affect if valuations correct?
Generally, high growth companies will have high PE due to high future expectations. It is very difficult for the companies to report high growth rate for years. The companies have to reinvent themselves into new verticals to sustain the growth for years, a very few companies will be like this.
Example: (Considering the similar size and business of the companies)
Company A is trading at 50 PE multiples with 20% EPS growth rate and Company B is trading at 30 PE multiple with 13% growth rate, Industry average PE is at 25 with 12% growth.
Say, over 5 years Company A and B growth rates started falling due to high market share/high revenue base. Company growth rate fell to 18% with 35 PE and company B growth rates fell to 13% with 25 PE.
Though Company A and B has grown faster compared to industry over 5 years, investors who brought at high PE has not benefited due to change in valuation.
Valuations paly a pivot role in the returns, paying a high price for a good company may not deliver high returns if PE corrects, so always be conscious about the price what you pay to buy a stock.
"Price is what you pay. Value is what you get." - Warren Buffett.