Investment basics - What is EPS, P/E ratio

When picking a stock for investment some important ratios are to considered, like EPS,P/E,ROE,ROC. Welcome to the world of financial accounting ratios. Confusing for some people and comforting for others, these tools can be highly effective in making investment decisions. Given their simplicity, a number-averse person too can use them. Significant amongst them is the concept of earning per share (EPS) and Price to Earnings Ratio P/E ratio.

The Earnings per share or EPS is simply the amount the company is worth per share of stock. It is calculated knowing the net earnings and the price of a stock.The Earnings per share is found by using the formula EPS= Net Income/Number of shares.

This is considered the most important way to determine the price of a stock according to fundamental analysis. It is also the key to determining the PE ratio which can tell if a stock is overpriced or under priced.

One thing you should remember is that the number of shares can change over time. Because of this it is important to take the average amount of shares when trying to determine the EPS.

The PE ratio (price to earnings ratio) measures a company's earning compared to the stock price. It helps tell if a stock is undervalued or overvalued.

The formula for the PE ratio is (Price of the stock)/ (earnings per share).

So if a stock, say RPL, is trading at Rs.150 and the earnings per share is Rs.10 the PE= 150/10 or 15. Historically the PE is normally between 10-20, however that does is not the benchmark for determining if a stock is undervalued or overvalued.

If you want to figure out if the Price to earnings is good or bad you have to compare it to other companies in the same industry group. This is because some industry groups will have higher PE'S in general then other industry groups.

This Ratio is supposed to state the investor's predictions for the stock. The reason the earnings per share is greater than the stock price is because the future growth of the company is also interpreted into that price.

It is for that reason that you not only have to look at other similar companies when determining if the PE is high but you also have to look at the growth of a company. If a company is growing very slow but the PE is 60 the stock is probably overpriced.

There are a few different problems you may encounter when using the PE ratio.

1. It is open for interpretation. In other words a PE might make a company look undervalued to you but overvalued to someone else.

2. It does not always give you a clear signal. A company with a high PE does not necesesarly have to come down just like a company with a low PE does not necessarily have to go up, or it may take many years before it happens.

Because the PE cannot be exactly right, it is important to combine it with other indicators before making your decision.