What is a PE Ratio?

Posted on Thursday, March 6th, 2025 | By IndusInd Bank

As an investor, before you choose a company to invest in, you look and assess various parameters. One such parameter many investors investigate before selecting a stock is the Price-to-Earnings or the PE ratio. 

So, what is a PE ratio and how can it help you as an investor?

Broadly put, PE ratio is an evaluation metric that helps investors assess the growth potential of a stock. Analysing the PE ratio allows you to review whether a stock is overvalued, undervalued, or fairly priced. 

Let’s explore more on the PE ratio meaning, its types, limitations, and more. 

Understanding the PE Ratio

The PE ratio is the price which an investor is willing to provide for ₹1 of the earnings-per-share of the company. 

To calculate the PE ratio, one must divide the current market price of the stock by the company’s annual earnings-per-share. 

Here’s the formula: 

PE ratio = Current market price of a share/Earnings Per Share (EPS)

So, if a company’s share price is ₹500 and the earnings-per-share is ₹10, the PE ration will be:

500÷10 = 50.

This means that investors are willing to pay ₹50 in the company’s stocks for ₹1 of their current earnings. 

· PE Ratios in Mutual Funds

For mutual fund portfolios, one can calculate the fund’s PE by first obtaining the PE ratio for each stock in the portfolio. Next, weigh each stock’s PE ratio as per its proportion in the portfolio. This will lead to the overall PE ratio of the mutual fund. You can look at the mutual fund’s monthly fact sheet to know its PE ratio.

· High and Low PE Ratios

If a company’s PE ratio in the stock market is high, it means that the company is overvalued. Investors may consider it to have growth potential. Hence, they are willing to pay a higher amount for the earnings-per-share of the company’s stocks. In a converse manner, a low PE ratio means the company’s stocks are undervalued. 

Types of PE Ratios

Now that we have discussed what the PE ratio is, let’s explore its types:

1. Forward PE Ratio

To reach the forward PE ratio, you need to divide the current price of a company’s stock by the projected/estimated earnings for the next 12 months. For this reason, it is also called an estimated PE ratio. 

Use: The forward PE ratio can help investors understand how a company may perform in the future and get a clear idea of its growth rate. 

Drawback: The forward PE ratio can be subject to errors, as it is based on forecasts. 

2. Trailing PE Ratio

In contrast to the forward PE ratio meaning, the trailing PE ratio uses the company’s past earnings from the last 12 months (or 4 quarters). 

Use: The trailing PE ratio gives a more accurate view of the company’s past performance, which can be an indication of its future growth as well. 

Drawback: While the trailing PE ratio is rooted in real data, it does not consider future challenges, whether expected or unexpected. 

Absolute and Relative PE Ratios

Another way investors classify the PE ratio in the share market is into absolute and relative types. 

• The absolute PE ratio refers to the standard calculation of the PE ratio as per the ratio given above. 

• However, the relative PE ratio uses the company’s current PE ratio to compare it to a benchmark or range of historical PE ratios. Usually, a particular period, such as 10 years, is taken into consideration, with the highest PE ratio value being given the focus. 

• In some cases, the relative PE ratio is calculated by comparing the company’s current PE ratio with the average PE of the industry/index benchmark.

Limitations of PE Ratios

While the PE ratio in the share market is useful, it has its limitations too:

1. Overlooks Debt:

The PE ratio meaning and calculation does not take into consideration the debt aspects of the company.

2. Does not Consider Industry Differences:

Different industries tend to have varying (average) PE ratios. This can make it difficult for investors to compare companies across sectors. 

3. Ignores Earnings Volatility:

A company’s earnings can fluctuate because of several reasons. The PE ratio does not take such factors into consideration. 

Hence, one must consider the PE ratio along with other financial metrics and criteria. Fund houses and mutual fund distributors offer many metrics and tools to help investors make wiser financial decisions. For instance, if you are planning to invest in mutual funds via a Systematic Investment Plan (SIP), you can use the SIP calculator to get an estimate of the returns. Such estimates, along with the PE ratio of the mutual fund, can guide one towards better investments.

Also Read: 5 Tips To Help You Manage Investments In Equity Mutual Funds In Over-Valued Equity Market

Conclusion

As an investor, you must learn about what the PE ratio is and how to use it to assess stocks before investing in them. However, one must also use other financial metrics and tools to ensure a holistic approach.

For a smooth mutual fund investment journey, consider investing via IndusInd Bank. With a variety of investment schemes to choose from, a one-click investment process, a transparent fee structure, and more, IndusInd Bank can be a worthwhile partner in your investment journey.  

Disclaimer: The information provided in this article is generic and for informational purposes only. It is not a substitute for specific advice in your circumstances. Hence, you are advised to consult your financial advisor before making any financial decision. IndusInd Bank Limited (IBL) does not influence the views of the author in any way. IBL and the author shall not be responsible for any direct/indirect loss or liability incurred by the reader for making any financial decisions based on the contents and information.