What is the significance of Price-Earnings (PE) ratio?

The PE ratio is the present price of the stock divided by the expressed earning per share of the stock. The PE of a stock is a subject to regular change. As the future retained earnings of a company are often found in the price of a stock, the PE ratio signifies up to what extent the stock price is valued at the earnings of the stock of the last year.

PE gives the price one is ready to pay for Re 1 of a company's earnings. As the future net earnings of a company is often uncertain, strong companies can extract a premium for their earnings from the investors. It has nothing to do that much with the returns a stock could deliver. So, one cannot use it as a means to forecast future performance. For example, a PE of 20 times does not show that the stock price will go up to 20 times. It means that investors are evaluating the stock at 20 times of its earnings.

Note − A PE ratio does not essentially mean to show actual earnings. It is just a measure that shows how much investors think the growth of the share price will be.

Price to book value ratio (PB) compares a share’s market value divided by its book value where book value is liabilities deducted from the assets. A lower PB means that the stock is undervalued or that something is fishy with the company and its shares. PE and PB are used together as tools for comparing shares belonging to a certain peer group of companies. PE alone does not signify anything.

PE in Mutual Funds

In case of mutual funds, the PE and PB are calculated by a weighted average of the inherent stocks. As a result, one shouldn't put too much importance to a mutual fund's PE and PB like that of a stock's PE. High PE and PB in this case would show that funds relative to a category holds stocks that are currently being quoted at a premium and pointing towards a growth-oriented strategy. If one is investing in a value fund, the fund will have a PE lower than that of growth funds.

When one wants to short-list funds, checking each fund's PE and PB can be quite a hard-working and misleading task.

Why Use the PE Ratio?

Investors want to buy stocks of financially sound companies that offer a good return on investment (ROI). The PE ratio is a part of the selection process as we can figure out whether we are paying a fair price for the stock while buying it depending on PE ratio.

Similar companies in the same industry are coupled together for comparison, regardless to the varying share prices.  Moreover, with PE, it’s easy and quick to use when we’re trying to value of a company using its earnings. A high or low PE will assess what kind of stock or company one is going to deal with.