Price earning (PE) ratio is the ratio which measures current price of a stock divided by the earning per share of the stock. It is calculated to see whether stock is undervalued or overvalued compare to its earnings. There are two types of PE ratios –
1. Absolute PE – It can be defined as ratio in which the nominator of this ratio is usually the current stock price, and the denominator may be the trailing EPS the estimated EPS for the next 12 months. When distinguishing absolute PE from relative PE, it is important to remember that absolute PE represents the PE of the current time period. For example, if the price of the stock today is $40, and the earning per share is $2 per share, then the PE will be 20 ($40/$2).
2. Relative PE – The relative PE ratio, on the other hand, is a measure that compares the current PE ratio to the past PE ratios of the company or to the current PE ratio of a benchmark over a relevant time period, such as the last 5 years. Relative PE shows what portion or percentage of the past PEs the current PE has reached. For example a company’s PEs over the last 5 years have ranged between 10 and 30. If the current PE ratio is 15, the relative PE comparing the current PE to the highest value of this past range is 0.5 (15/30), and the current PE relative to the low end of the range is 1.5 (15/10). Hence, the closer the current PE gets to the high side of the range and further away from the low side, it means that stock is overvalued.
Though Absolute PE, compared to relative PE, is the most-often used measure in most of the countries in the world