Price Earning (PE) Ratio

Price Earning Ratio is a type of Profitability Ratio that determines the Market Price of share relative to its Earning Per Share. It is a measure to check how well equity is priced in a market.
Price Earnings (PE) Ratio = Market Price Per Share / Earnings per Share
Where,
  • Market Price Per Share is the price at which common equity is trading in the market.
  • And EPS = Net Profit / Total Number of Common Equity.

Significance and Interpretation

  • PE ratio helps investors to determine the pricing standard of equities in the market, a higher PE indicates that a share is highly-priced with respect to its EPS.
  • Investors are attracted by the lower PE ratio of stock as it assures that the equity is priced correctly with respect to its EPS.

Examples

Example 1: Given below are few details of M/S XYZ Ltd. and ABC Ltd., use them an calculate the PE Ratio for M/S XYZ Ltd and ABC Ltd. and decide which investment is better.
Particulars (XYZ Ltd.) Amount (in Rs.) (ABC Ltd.) Amount (in Rs.)
Equity Share Capital @ Rs 10.00 each 5000000.00 5500000.00
Market Price Per Share 40.00 10.00
EBIT (Earnings Before Interest and Taxes) 4000000.00 2500000.00
Interest Expenses 1000000.00 800000.00
Tax Payable 500000.00 300000.00
  • Solution:
  • 1. XYZ Ltd.
    • Net Profit = EBIT – Interest Expenses – Tax payable = Rs. 2500000
    • Total Number of Common Equity = 5000000 / 10 = 500000
    • EPS = Net Profit / Total Number of Common Equity = 2500000 / 500000 = Rs. 5
    • PE Ratio = Market price Per Share / EPS = 40/5 = 8
    • Hence, Market Price per Share of XYZ Ltd. is 8 times the annual earning of the share
  • 2. ABC Ltd.
    • Net Profit = EBIT – Interest Expenses – Tax payable = Rs. 1400000
    • Total Number of Common Equity = 5500000 / 10 = 550000
    • EPS = Net Profit / Total Number of Common Equity = 1400000 / 550000 = Rs. 2.54
    • PE Ratio = Market price Per Share / EPS = 10/2.54 = 3.94
    • Hence, Market Price per Share of ABC Ltd. is 3.94 times the annual earning of the share
By comparing the PE Ratio for both the companies, it can be concluded that Shares of ABC Ltd. are more correctly priced as compared to shares of XYZ Ltd.
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