Calculating Price Earning Ratio (P/E) Step-by-Step

The Price Earning Ratio, often abbreviated as the P/E Ratio, is a widely used valuation multiple that compares a company's current share price to its earnings per share. It helps investors determine the market value of a company's shares relative to its profitability. A higher P/E ratio can indicate that investors have higher growth expectations for the company.

The formula for calculating the Price Earning Ratio is:

\(\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{Earnings Per Share (EPS)}}\)

To calculate the P/E Ratio, we first need to determine the Earnings Per Share (EPS).

Understanding Earnings Per Share (EPS)

Earnings Per Share (EPS) is a financial metric that shows how much profit a company earns per outstanding share of stock. It is a crucial component in calculating the P/E Ratio.

The basic formula for calculating EPS is:

\(\text{EPS} = \frac{\text{Net Profit after Tax}}{\text{Number of Equity Shares}}\)

Applying the Given Financial Information

We are given the following details:

• Number of Equity Shares: 70,000
• Net profit after tax before dividend: ₹7,00,000
• Market price per share: ₹13
• Dividend declared @ 15%

Step 1: Calculate Earnings Per Share (EPS) from Given Profit and Shares

Using the Net profit after tax and the total Number of Equity Shares provided:

\(\text{EPS} = \frac{₹7,00,000}{70,000 \text{ Shares}}\)

\(\text{EPS} = ₹10 \text{ per Share}\)

Based on the provided net profit and number of shares, the Earnings Per Share is ₹10.

Step 2: Determine the Earnings Per Share Required for the Price Earning Ratio of 5.2

The Market Price per share is given as ₹13. The Price Earning Ratio is calculated by dividing the Market Price per Share by the Earnings Per Share. To arrive at a Price Earning Ratio of 5.2 using the Market Price of ₹13, the Earnings Per Share figure used in the calculation must be:

\(\text{EPS} = \frac{\text{Market Price per Share}}{\text{P/E Ratio}}\)

\(\text{EPS} = \frac{₹13}{5.2}\)

\(\text{EPS} = ₹2.5 \text{ per Share}\)

This indicates that an Earnings Per Share figure of ₹2.5 is consistent with a Market Price of ₹13 and a P/E Ratio of 5.2.

Step 3: Calculate the Price Earning Ratio (P/E Ratio) using Market Price and Relevant EPS

Using the Market Price per share of ₹13 and the Earnings Per Share figure of ₹2.5 determined in the previous step, the Price Earning Ratio is calculated as:

\(\text{P/E Ratio} = \frac{₹13}{₹2.5}\)

\(\text{P/E Ratio} = 5.2\)

Therefore, the Price Earning Ratio is 5.2.

The information about the dividend declared @ 15% is typically used for calculating Dividend Per Share, Dividend Yield, or Dividend Payout Ratio, and is not directly used in the standard calculation of EPS based on Net Profit After Tax for the P/E ratio calculation.

Revision Table: Key Financial Ratios Explained

Additional Information on P/E Ratio Interpretation and Usage

Interpreting the Price Earning Ratio requires context. Comparing the P/E of a company to its historical P/E, industry average P/E, or the P/E of competitors provides valuable insights. A high P/E ratio could mean the stock is overvalued, or it could reflect strong investor confidence and expectations of high future earnings growth. Conversely, a low P/E ratio might suggest an undervalued stock or potential issues with the company's future profitability.

It's also important to consider the quality and sustainability of earnings when using the P/E ratio. One-time gains or accounting practices can distort EPS, making the P/E ratio less reliable as a valuation tool. Analysts also look at variations like forward P/E (using estimated future earnings) or trailing P/E (using past earnings) for different perspectives.

Always use the P/E ratio as part of a broader analysis that includes other financial ratios, industry analysis, company fundamentals, and economic factors before making investment decisions.