Price-to-Earnings (P/E) Ratio: Types, Market Cycles & Limitations

The Price-to-Earnings (P/E) ratio is the widely used metrics in stock market investing. It offers insight into how much investors are willing to pay for a company’s earnings. While simple in calculation, its interpretation requires a nuanced understanding of market conditions, industry trends, and company fundamentals. P/E ratios vary across growth and value stocks, fluctuate with market cycles, and come with limitations that can mislead investors if used in isolation.

What is the P/E Ratio?

The Price-to-Earnings (P/E) ratio reflects how much investors are ready to pay for each rupee of a company’s earnings. It helps assess whether a stock is relatively expensive, fairly valued, or undervalued compared to its earnings.

In simple terms, the P/E ratio compares the current market price of the company to its earnings per share (EPS). A higher P/E ratio indicates that investors expect higher future growth and are ready to pay a premium today.

The P/E ratio helps in comparing companies within the same industry, as valuation standards vary across sectors. For example, technology companies often trade at higher P/E ratios because of their growth prospect, while mature industries like utilities typically trade at lower P/E ratios. It is also used to compare a stock’s current valuation with its historical average or the broader market index.

If you are wondering how to calculate P/E ratio, the standard formula is:

P/E Ratio = Market Price per Share ÷ Earnings per Share (EPS)

Types of P/E Ratios

Price per earning ratios can be of the following types:

Trailing P/E Ratio

The trailing P/E ratio measures the current share price of a company relative to its EPS over the past 12 months (TTM). It shows how much investors are willing to pay today for each rupee of historical earnings, based on actual, already reported profits rather than estimates.

To calculate the trailing P/E ratio, you can use the following formula: 

Trailing P/E Ratio = Current Market Price per Share ÷ Earnings per Share (EPS) of the last twelve months. 

For example, if the shares of an XYZ company are trading at ₹600 and its total EPS over the last four quarters is ₹30, the trailing P/E ratio would be 20 (₹600 ÷ ₹30). 

Forward P/E Ratio

The Forward PE Ratio checks the valuation of the company based on its expected future earnings rather than past profits. To compute, use the following formula:

Forward PE Ratio = Current Market Price per Share ÷ Estimated Earnings per Share (EPS) for the next year. 

Suppose a stock trades at ₹600, and analysts expect next year’s EPS to be ₹50; the forward PE is 12. This helps compare growth expectations across companies.

Shiller P/E Ratio (CAPE)

The Shiller P/E Ratio or CAPE (Cyclically Adjusted Price-to-Earnings) uses average inflation-adjusted earnings from the past 10 years to determine stock market valuation. The purpose is to smooth out economic cycles and temporary profit spikes. 

To compute shiller P/E, you can use the following formula:

Shiller P/E (CAPE) = Current Market Price ÷ Average of inflation-adjusted earnings over the last 10 years

For example, if an index is trading at ₹30,000 and its average inflation-adjusted earnings over the last 10 years are ₹1,500, the CAPE ratio is 20 (30,000 ÷ 1,500). A lower CAPE indicates relatively cheaper markets.

Other P/E Variants

PEG Ratio

The PEG Ratio (Price/Earnings to Growth ratio) helps you assess whether a stock is fairly valued by considering both its price and expected earnings growth. You can compute this using the formula below:

PEG Ratio = (Price-to-Earnings Ratio ÷ Annual Earnings Growth Rate)

Assume a company’s stock has a P/E ratio of 20 and its expected annual earnings growth rate is 10%. The PEG ratio would be 20 ÷ 10 = 2. A PEG ratio of 1 is generally considered fairly valued, below 1 may indicate undervaluation, and above 1 may suggest overvaluation. In this example, a PEG of 2 indicates the stock price is high relative to its growth prospects. The PEG ratio is especially handy when comparing growth stocks across sectors.

Normalised P/E

Normalised P/E adjusts the earnings of the company to show its average, sustainable performance instead of short-term highs or lows. It is especially useful for cyclical businesses where profits fluctuate due to economic conditions.

To compute, use the following formula:

Normalised P/E = Current Market Price per Share ÷ Normalised Earnings per Share

Take a hypothetical example of a steel company that earns ₹100 per share during an economic boom. Though its historical average earnings stood at ₹50 per share. If the stock trades at ₹1,000, the reported P/E looks attractive at 10. However, using normalised earnings, the P/E rises to 20.

Understanding P/E in Different Market Cycles

Here is how P/E earning operates in different market cycles:

• During the bull phase, stock prices rise much faster than earnings. The reason? Investors are optimistic about future growth. The result? P/E ratios increase.
• During bear markets, falling prices and weak sentiment usually push P/E ratios lower, even when company earnings stay unchanged.
• Market corrections and recessions generally lead to shrinking earnings and fluctuating stock prices. P/E ratios can become volatile, sometimes rising if earnings fall faster than prices.
• In sideways or range-bound markets, prices remain relatively stable while earnings gradually grow. P/E ratios in such markets tend to stabilise.

Limitations of the P/E Ratio

Here are some of the key limitations of the P/E ratio: 

Earnings Manipulation

Earnings manipulation occurs when a company adjusts its reported profits through accounting techniques rather than genuine business growth. For example, a company may recognise its future sales prematurely to inflate current profits. The result? Temporarily lowering of the P/E ratio. Conversely, excessive provisions can reduce reported earnings and can artificially raise the P/E. 

No Consideration for Growth

The P/E ratio ignores future growth. For example, Company A and Company B both trade at a P/E of 20. Company A is expected to grow earnings by 25% annually, while Company B’s earnings are stagnant. Despite identical P/E ratios, Company A offers stronger future potential.

Loss-Making Companies

If the company reports zero or a negative earnings, it is not possible to use the P/E ratio as the denominator is invalid. For example, a startup with a market price of ₹200 per share reports earnings of –₹10 per share. Here, the P/E ratio would be –20, which is not interpretable. In such cases, you should rely on Price-to-Sales (P/S) or EV/EBITDA to assess valuation.

Industry Variance

Industries differ in expected growth, funding needs, and inherent business risks. You will generally find IT sector companies having a high P/E ratio in the range of 30 to 40. The reason? They have better growth prospects and low capital needs. In contrast, utility companies are stable but slow-growing, with typical P/E ratios around 10–15.

If you compare a tech company with a P/E of 35 to a utility company with a P/E of 12, it might seem that the tech stock is overvalued. However, the higher P/E reflects the tech sector’s growth potential, while the lower P/E in utilities is normal for its slower growth. 

Impact of Debt 

The P/E ratio does not account for how a company finances its operations. It ignores the impact of debt on financial risk. For example, consider two companies, A and B, both with earnings of ₹10 crore and a share price of ₹200, giving a P/E ratio of 20.

• Company A has no debt and generates earnings purely from operations.
• Company B has significant debt.

Even though both trade at a P/E of 20, Company B is riskier since heavy debt raises default chances in weak markets and interest costs can eat into future profits.

Influence of Market Sentiment

Market sentiment directly impacts share prices, which in turn affects the P/E ratio even when earnings remain unchanged. For example, assume a company earns ₹10 per share. At a share price of ₹200, its P/E ratio is 20. During a bull market, strong optimism may push the price to ₹300 without any earnings growth, raising the P/E to 30. 

 

Conversely, during a market correction, fear may drag the price down to ₹150, lowering the P/E to 15. In both cases, earnings stay the same, but the P/E ratio changes purely due to investor emotions, not business fundamentals.

Tips to Use the P/E Ratio Effectively

Here is how to use the P/E ratio to avoid misinterpretation:

• Check the historical P/E data to understand how the stock has been valued over time.
• Evaluate a stock’s P/E against the broader market or index to understand if it is overvalued or undervalued.
• Pair P/E with metrics like ROE, debt ratios, or cash flow to avoid misleading conclusions.
• Be cautious if you notice that the high P/E results from one-time gains or accounting adjustments, as these can inflate earnings and mislead valuation.
• Consider macroeconomic factors like inflation and interest rates, which influence market P/E levels.

Conclusion

The P/E ratio helps gauge stock valuation, but you should never view it in isolation. Always consider company growth, industry context, market sentiment, and financial health alongside P/E to make informed decisions. Understanding its types and limitations allows you to interpret ratios more effectively, identify potential opportunities, and avoid common pitfalls. By combining P/E with complementary metrics, you gain a clearer, more balanced perspective on a stock’s true investment potential.