Price to Earning Ratio (P/E) is a very important tool which is  frequently used for selection of stocks. It is obtained by dividing the market price of a stock by its annualized EPS and naturally changes daily with the share price movement. It measures a company’s current stock price in relation to the company’s EPS. High P/E ratio indicates the high price of a stock and low P/E ratio indicates its low price and offers a choice to the investors for selection of stocks. Companies with relatively lower P/E ratio generally offer better investment opportunities while companies with higher P/E ratio are generally accepted as overvalued stocks. Depending upon different phases of the stock market, P/E ratios of companies differ – higher in the bull market and lower in its bear phase. The P/E ratio also differs from stock to stock and even among the stocks of the same industry. Depending upon growth prospects and other factors of a particular company, the dynamics of each company needs to be carefully studied to find out which company is undervalued and which is overpriced. While trailing EPS and P/E ratio are available to us and guide us for stock picks, forward EPS estimation (say for next many quarters) is more important. It depends upon a lot of factors including whether the company is adding new capacities, developing new products, improving its product quality, taking steps for improving its profit margin and most importantly whether  the price and demand of its products will enhance. In purchasing shares it has to be ensured that the estimated earnings of the company are not already built up in the stock price.

Companies with uninterrupted growth prospects such as pharma, consumer products, information technology etc. command higher P/E ratio while cyclicals which do not have consistent growth have lower P/E ratio. However, some of the cyclicals which have achieved stability in their businesses have comparatively high P/E ratio. Again, cyclicals command a high P/E ratio when their growth and business prospects brighten up. Some engineering, construction and cement companies for example in India look promising and consequently their P/E ratio is high. Conversely, when the growth prospects of the high growth companies plateau their P/E ratio comes down. Normally, cyclicals command a P/E ratio within the range of 10-15 or slightly more while the P/E ratio of companies with high growth prospects range from 20 and upwards.