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There isn't a huge difference between these variations. But it is important to realize that, in the first calculation, we are using actual historical data. The other two calculations are based on analyst estimates that are not always perfect or precise.

Companies that aren't profitable, and consequently have a negative EPS, pose a challenge when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say there is a negative P/E; others give a P/E of 0, while most just say that the P/E doesn't exist.

Historically, the average P/E ratio in the market has been around 12-30. This fluctuates significantly depending on economic conditions at the time. The P/E can also vary widely between different companies and industries.

Using the P/E Ratio

The P/E ratio for a growth stock should equal the growth rate of earnings.

This implies: -

If the P/E Ratio < EPS Growth Rate:
A stock is under priced.

If the P/E Ratio = EPS Growth Rate:
A stock is fairly priced.

If the P/E Ratio > EPS Growth Rate:
A stock is overpriced.

This is because earnings provide the fuel for growth. To some degree, a company's stock will rise and fall based on reported earnings and changes in forecast future earnings. The stock price, then, is determined by how quickly earnings grow, and how earnings are expected to grow in the future.

Unfortunately, future earnings and future growth rates are not known with any certainty. They are available only as forecasts or estimated earnings. That makes pricing the stock problematic.

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* Contributed by: -
Varun Dawar,
PGDBM, Batch 2004-06,
Institute of Management Technology (IMT), Ghaziabad.