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What is Price-earning ratio (PE)?

The PE ratio of a stock is a measure of the price paid for a share relative to the annual net income. That means how much rupee you are paying for each rupee of net income.

It is common practice for investor to use the PE ratio to determine company’s stock price is overvalued or undervalued. Companies with a high PE ratio are typically growth stocks. However, their relative high multiples don’t necessarily mean that their stocks are overpriced and not good in the long term.

PE Ratio= Market value per share/ Earning per share (EPS)

Share prices in a publicly traded company are determined by market supply and demand and thus depend upon the expectations of buyers and sellers. There are other factors that affect the value of a stock. Example

  • Brand
  • Human Capital
  • Expectation
  • Barriors to Entry

All these factors will affect a company’s earning growth rate. Because the PE ratio uses past earnings (Trailing twelve months, TTM), it gives a less accurate reflection of these growth potentials.