In company analysis, while making portfolio, an investor tries to forecast and estimate the future

earnings of the company which effect company share price directly. There are number of factors
which affect the stability of earnings of a company and an potential investor always emphasis on
firms’ trends of earnings, other financial parameter like dividends, capex, bonus issues, rights
shares along with change in market value of the share along with the prospect of rise in value of
the firm. The screening process to select securities from large number of securities not only
depends on the objectives and risk tolerance of the investors rather, stocks are screened out on
the basis of annual growth for sales and earnings, dividend payout, ROI, ROE, P/E ratio, β,
liquidity standard through acid test, turnover ratio debt equity mix and invest coverage ratio and
ultimately marketability of stock on the basis of trading volume weekly or daily. Out of all, EPS
and P/E ratio are considers significant parameters.
Price to Earning (P/E) ratio is calculated as the price of share divided by EPS, i.e. consider two
factors Market price of the Share (MPS) and Earnings per Share (EPS). P/E ratio is the reciprocal
of earnings yield (i.e. earnings-price ratio). This ratio indicates the investor’s expectation on the
particular stock in relation with its actual earnings, a most important ratio for guessing the price
of a share. EPS is net profit calculated on a trailing 12 months basis (aggregate net profit of four
consecutive quarters) divided by fully diluted equity capital. The P/E ratio indicates the number
of times the price of a share is more than its EPS. The industry P/E is the aggregate market
capitalization of the industry divided by the aggregate standalone net profit (trailing 12 months)
of the industry, after excluding loss making companies. Change in P/E occur because either EPS
or price changes.
A company having a P/E ratio of 8, has its price 8 times over its EPS. The P/E ratio reflects the
company’s growth prospects, risk characteristics, shareholder orientation, corporate image, and
degree of liquidity.
However, P/E ratio can mislead about the performance of a share. A high P/E ratio is considered
good but it may be high not because the share price is high rather due to low EPS. P/E ratio has
limitations and may be changed by accounting policies as EPS, which may distort the fair
estimation of earnings. So, it becomes difficult to interpret EPS meaningfully and rely on EPS
and P/E ratio as measure of performance. Even if the profit earning potential of a company is
high, if its equity base is large, the EPS and hence MPS would be low. When a company declares
rights or bonus, or if its debentures are converted, its equity rises, diluting the EPS. Some
Companies shows Positive EPS but Negative CEPS, since Credit Sales is more.
Further, a low P/E does not mean a buying opportunity, as Infosys like company which has high
P/E above than 25, still preferred by investors against low P/E companies, due to expected future
growth rate. Infosys inspite of its high P/E ratio has been preferred to other company because of
its growth rate, liquidity and faith in management. An appropriate P/E estimated on the basis of
growth rate of earnings, both past and present, past sales growth, stability of past earnings,
financial strength, nature of industry, competitive position of the company.
Further, Trailing P/E is based on current MPS and historic EPS, although not very useful because
stock selection is a forward looking exercise while trailing P/E is based on past performance.
Whereas, 1-Year forward P/E is based on current MPS and expected EPS” for the next year,
depending on EPS growth for the next year. If EPS is Rs 10/ for the year ending march 31, 2018,
with expected growth on earnings is 20%, then EPS for the year ending march 31, 2019, is likely
to be Rs 12 per share as per our expectations. Similarly, 2-Year forward P/E is calculated.
Forward P/Es can be used to invest in stocks as they give certain basic information regarding
their performance in the future. P/Es concepts are used in balancing portfolios. Portfolio
managers also use another variations, PEG (P/E divided by the earnings growth rate) similar to
forward P/E. The PEG, a variant of the P/E ratio, considers the annualized rate of growth of EPS
and compares this with the current stock price.
[P/E of 10] / [10% EPS growth] = 1.0 PEG
A PEG of 1 implies that a company is fairly valued. If the company has a P/E of five with
expected growth of 10% a year, then PEG will be 0.5, i.e. selling at one half of its fair value.
The PEG ratio (P/E to Growth ratio) is a valuation metric for determining the relative trade-off
between the price of a stock, the earnings generated per share (EPS), and the company's expected
growth. Normally, the P/E ratio is higher for a company with a higher growth rate and using only
the P/E ratio may make high-growth companies to be overvalued in relation to other companies.
That’s why, dividing the P/E ratio by the earnings growth rate, gives out the better understanding
for comparing companies with different growth rates. The PEG ratio was originally developed by
Mario Farina in her famous book, A Beginner's Guide To Successful Investing In The Stock
Market (1969) and further by Peter Lynch, in One Up on Wall Street(1989) that "The P/E ratio of
any company that's fairly priced will equal its growth rate", i.e., a fairly valued company will
have its PEG equal to 1.
A lower PEG ratio means stock is undervalued i.e. cheaper, whereas, a higher ratio reflects it is
overvalued means expensive. In practice, researcher considers Projected or trailing P/E ratio and
expected growth rate for the next year or the next five years. Since, PEG considers growth factor
also, hence preferred along with P/E ratio. PEG values between 0 and 1 may preferred as it
reflect higher returns.
PEG is used for growth companies; the YPEG is suitable for valuing larger, more-established
ones. The YPEG uses the same assumptions as the PEG but use different numbers. In developed
markets, where most Earnings Estimate Services provide estimated 5-year growth rates, these are
simply taken as an indication of the fair multiple for a company’s stock going forward. Thus, if
the current P/E is 10 but analysts expect the company to grow at 20% over the next five years,
the YPEG is equal to 0.5 and the stock looks cheap according to this metric. PEPG is the P/E
(price/earnings) ratio over past growth. It divides the P/E ratio by the average EBITDA growth
rate over the past five years.