The P/E ratio measures how cheaply valued a company's stock price is by comparing the current stock price to its earnings-per-share (EPS). Earnings are synonymous with net income (NI) or profit while EPS is calculated by dividing net income by the total number of a company's outstanding equity shares. If EPS rises and the stock price remains the same, the P/E will fall. As a result, the stock would have a cheaper valuation since investors would receive more earnings relative to the company's stock price.
Conversely, a high P/E ratio could mean a company's stock price is overvalued. However, the higher P/E ratio can also mean that a company is growing, with its stock price and EPS both rising. A rise in the P/E ratio for a company could be due to improving financial fundamentals, which could justify the higher valuation. Whether a company's P/E represents a good valuation depends on how that valuation compares to other companies in the same industry.
Get to know the nitty-gritty of picking the right stocks using PE and EPS ratios. Knowing about these ratios will help you design the right strategy for low PE ratio stocks as well as high PE stocks.