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What are the P/E ratio and PEG? Why are they important in evaluating a stock?

In this Demystifying Investment series, we simplify and explain some of the standard terms (jargon) that are essential to making sound investment decisions.

Very often, you will hear of investors benefiting from undervalued stocks which eventually gained a lot of momentum. Investors also lose money in an overvalued stock that rolled down in value after its 15 minutes of fame. But there’s more to the terms ‘overvalued’ and ‘undervalued’ than what novice investors may perceive them to be.

Evaluating the value of a listed company’s stock is the first step investors and fund managers follow to shortlist their investment options. And a simple formula they all use to do so is by comparing the company’s price-to-earnings (P/E) ratio and the price/earnings-to-growth (PEG) ratio with its industry group or a benchmark market.

Understanding P/E Ratio & PEG Ratio

What Is P/E Ratio?

The price-to-earnings ratio is a simple evaluation of a company’s current stock price with respect to its net earnings per stock, also termed as earnings-per-share (EPS). The EPS value is derived simply by dividing the current net earnings of the company by its number of outstanding stocks. This value is calculated for a fixed time period, usually 12 months.

What Does it Mean? ➔ A company with a higher stock price but lower earnings per share would yield a higher P/E value, meaning it is overpriced or overvalued. ➔ A company with a similar stock price and higher earnings per share will have a lower P/E value, meaning it is undervalued. ➔ A company whose stock price matches its earnings per share is considered fairly valued.

For example, if a stock has an EPS of $2 over the past year and is currently trading at $10 per share, its current P/E value would be 5 (10/2). A professional analyst would say that this stock is trading at five times earnings.

The P/E ratio helps you determine the intrinsic value of a stock as compared to the company's earnings.

The P/E ratio can be calculated to learn a stock’s historical value as a trailing ratio or its future potential value as a forward ratio.

Limitations of the P/E Ratio

While investors prefer considering a company’s P/E as a judge of its performance, here are a few reasons why it should be used with a pinch of salt: