In order to follow and better understand prices of stocks, it is generally recommended to have a working knowledge of the main valuation ratios, even if you do not use them yourself. P/E is the price-to-earnings ratio and EPS is the earnings per share.
Earnings per share: This measure is calculated by taking the net income earned by the corporate and dividing it by the number of outstanding shares issued.
Price / Earnings ratio: P/E ratio is measured by dividing the share price by the earnings per share.
P/E and EPS are two of the most frequently used ratios.
Valuation ratios
Many investors use P/E and EPS to understand if a share is correctly valued. This is fundamental analysis. While it is never advisable to use a share price ratio in isolation (it should always be compared to its industry or market peers), these ratios are used frequently. Historically they have proven to be reliable methods of uncovering intrinsic value, or showing if a share price is “cheap”.
Case study
By using a fictional company, we can illustrate how these ratios are used.
“AB Group” is a professional services company and trades on the BSE. They provide a variety of IT and management services to India’s largest companies.
AB Group’s key financial data is listed below; it has a 12-month forecast sales of Rs 1,20,000 and 2,000 shares outstanding. AB Group’s closing share price was Rs 10.
Note: the numbers used in this example have been kept deliberately simple; therefore, the ratios do not represent values which are normally found.
The calculation for the P/E ratio is Market Price per Share / Earnings per Share.
The calculation for EPS is (Net income – dividends on preferred stock) / Average outstanding shares
| Key financials | Key financials | Year 2 12-month forecast / estimate) |
|---|---|---|
| Revenue | 1,00,000 | 1,20,000 |
| Earnings | 4,000 | 5,000 |
| Shares outstanding | 2,000 | 2,000 |
| Valuation ratios | ||
| EPS | (4,000/2,000) = 2 | (5,000/2,000) = 2.5 |
| PE | (Share price:10/2) = 5 | (10/2.5) = 4 |