In this blogpost I try to help my readers understand one of the most popular profitability ratios of all time; the Price to Earnings Ratio or as is popularly known as the PE ratio. With the disproportionately high focus that PE multiples have attracted over time, it is important for every investor to understand whether this valuation metric really lives up to the hype surrounding it.

So what does a PE ratio tell you, and more importantly what it doesn’t?

A PE ratio gives us the relationship between the current market price of a company’s share relative to the earnings it generates per share. Here’s the formula:

P/E = Current Market Price of a Share / Earnings Per Share

In other words, a PE ratio tells us what the market is willing to pay for every rupee of earnings generated. For instance, if a company ABC is trading at a PE of 25, it means that participants are willing to pay Rs.25/- for every Re.1 earned. However, the PE ratio, is often loosely interpreted by many, to determine whether a company’s share is undervalued, fairly value or overvalued. While there’s no universally accepted benchmark PE figure; comparisons are drawn based on where the company’s peers stand, the industry average and the company’s own historical PE.

The Price to Earnings Ratio is one of the most commonly used measures of relative valuation across the globe. However, as with any other relative valuation measure, A PE ratio looks at the value of an asset relative to other similar assets traded in the market, but tells very little about the real value of the asset.

Let me demonstrate this with the help of an example.

Consider two Companies ABC ltd. & XYZ ltd. in the same industry. Let’s say ABC is trading at a PE of 25 while XYZ is trading at a PE of 40. Let’s say both companies generate the same earnings. Going purely by traditional wisdom on PE ratios, one would be tempted to believe that ABC, given its lower PE is comparatively undervalued than XYZ. However, when digging deeper into the companies’ fundamentals, one realizes that XYZ is far more capital efficient and is able to generate the same earnings as Company ABC, but at a far lower capital requirement than Company ABC (let’s say in this case the capital requirement for XYZ is 50% lower as compared to Company ABC). In other words, XYZ is twice as capital efficient as ABC. This means that the earnings growth generated by XYZ will be double for the same level of capital employed. Seen in this light, the PE commanded by Company XYZ is quite justified. Thus the argument “Low PE = Better Value” falls flat in this case.

In fact, many of the high growth companies command a Higher PE; higher capital efficiency being one of the reasons. Similarly, in many cases companies trading at very low PEs could actually be trading at low multiples for a reason and might well deserve being traded at a low PE. While visually high PEs could blindside us to the many potential investment opportunities that come our way, low PEs on the contrary could create an illusion of value, leading uninformed investors inadvertently chasing an investment value trap. Thus blanket generalizations based on PE ratios alone may end up giving a misleading picture of the company’s value. A PE multiple should therefore, at best, be one of the many tools to aid you in your valuation process and not a core valuation metric in itself.

So stop fixating on PEs and look at a company for what it is really worth!