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.
$$Price\quad Earnings\quad Ratio=$$$$\frac { Market\quad price\quad Per\quad Share }{ Earning\quad Per\quad Share } $$ Market Price Per Share is the price at which common equity is trading in the market. Where,
And $$Earning\quad Per\quad Share=$$$$\frac { Net\quad Profit }{ Total\quad Number\quad of\quad Common\quad Equity } $$
$$Price\quad Earnings\quad Ratio=$$$$\frac { Market\quad price\quad Per\quad Share }{ Earning\quad Per\quad Share } $$ Market Price Per Share is the price at which common equity is trading in the market. Where,
And $$Earning\quad Per\quad Share=$$$$\frac { Net\quad Profit }{ Total\quad Number\quad of\quad Common\quad Equity } $$
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
Total Number of Common Equity = 5000000 / 10
⇨ 500000
EPS = Net Profit / Total Number of Common Equity
EPS = Net Profit / Total Number of Common Equity
⇨ 2500000 / 500000
⇨ Rs. 5
PE Ratio = Market price Per Share / EPS
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.
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
Total Number of Common Equity = 5500000 / 10
⇨ 550000
EPS = Net Profit / Total Number of Common Equity
EPS = Net Profit / Total Number of Common Equity
⇨ 1400000 / 550000
⇨ Rs. 2.54
PE Ratio = Market price Per Share / EPS
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.
Hence, Market Price per Share of ABC Ltd. is 3.94 times the annual earning of the share.
