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In order to follow and better understand prices of stocks, it is generally recommended to have a working knowledge of the main valuation ratios, even if you do not use them yourself. P/E is the price-to-earnings ratio and EPS is the earnings per share.

Earnings per share: This measure is calculated by taking the net income earned by the corporate and dividing it by the number of outstanding shares issued.

Price / Earnings ratio: P/E ratio is measured by dividing the share price by the earnings per share.

P/E and EPS are two of the most frequently used ratios.

Valuation ratios

Many investors use P/E and EPS to understand if a share is correctly valued. This is fundamental analysis. While it is never advisable to use a share price ratio in isolation (it should always be compared to its industry or market peers), these ratios are used frequently. Historically they have proven to be reliable methods of uncovering intrinsic value, or showing if a share price is "cheap".

Case study

By using a fictional company, we can illustrate how these ratios are used.

"AB Group" is a professional services company and trades on the BSE. They provide a variety of IT and management services to India's largest companies.

AB Group’s key financial data is listed below; it has a 12-month forecast sales of Rs 1,20,000 and 2,000 shares outstanding. AB Group’s closing share price was Rs 10.

Note: the numbers used in this example have been kept deliberately simple; therefore, the ratios do not represent values which are normally found.

The calculation for the P/E ratio is Market Price per Share / Earnings per Share.

The calculation for EPS is (Net income – dividends on preferred stock) / Average outstanding shares

The shares of “CD Group”, a competitor, are trading at ratios higher than AB Group. The P/E ratio for CD Group is 8, while the EPS is 5. When you compare AB Group’s ratios to CD Group’s, AB Group is trading at a discount to CD Group. This might lead you to conclude that AB Group’s shares are cheap and worth buying.

Although this may be the case, do not forget to conduct further research into the company. You may find that, for example, AB Group has just lost a major contract, or CD Group has appointed a CEO with a strong reputation for cost cutting. However, if the market also decides that AB Group is cheap you will see the share price increase over time and close the valuation gap with its peers.