Understanding the P/E Ratio: How It Explains Company Valuation, The Question Every Investor Asks | Quick ₹eads

by Karnivesh | 25 December, 2025

Imagine you walk into a market and see two apples. The first apple is priced at ₹10, and the second at ₹50. Your immediate instinct is: the second apple is expensive, right? But what if the second apple is organic, locally sourced, and stays fresh for 30 days, while the first apple is conventional and rots in 3 days? Suddenly, ₹50 might be the bargain.

This is exactly how the P/E ratio works in the stock market. It answers one deceptively simple question: "How much am I paying per rupee of the company's earnings?" Without this answer, comparing stock prices is like comparing apple prices without knowing their quality or shelf life.

Two stocks might both trade at ₹300. But if one company earns ₹15 per share annually and the other earns ₹30, you're actually paying different amounts for the same price. This is the power of the P/E ratio it reveals what you're truly paying.

What Is the P/E Ratio, Really?

The P/E (Price-to-Earnings) ratio is calculated using a simple formula:

P/E = Share Price ÷ Earnings Per Share (EPS)

That's it. But the implications are profound.

Let's say a company's stock trades at ₹900 per share. The company has earned ₹30 per share over the last 12 months. The P/E ratio is 900 ÷ 30 = 30.

What does a P/E of 30 mean? It means investors are willing to pay ₹30 in stock price for every ₹1 the company earns. If you buy that stock, you're essentially saying: "I believe this company's earnings will grow fast enough or are stable enough to justify paying 30 times its current annual profit."

Conversely, you can flip this around to calculate the earnings yield, which is the inverse: 1 ÷ 30 = 3.3%. This means the stock is giving you a 3.3% return based on current earnings. If a fixed deposit in your bank offers 7%, suddenly that stock looks less attractive unless you believe earnings will grow significantly.

This is the key insight: P/E is the language the market uses to express confidence (or doubt) about a company's future.

The Story of Two Companies Trading at the Same Price

Imagine two companies, both listed on the stock exchange, both trading at exactly ₹300 per share.

Company A (A Traditional Manufacturer)

• Share price: ₹300

• Annual earnings per share: ₹15

• P/E ratio: 300 ÷ 15 = 20

• Earnings yield: 1 ÷ 20 = 5%

Company B (A High-Growth Tech Startup)

• Share price: ₹300

• Annual earnings per share: ₹30

• P/E ratio: 300 ÷ 30 = 10

• Earnings yield: 1 ÷ 10 = 10%

Both stocks cost ₹300. Both have the same market price. But Company B is fundamentally "cheaper" on earnings because you're only paying ₹10 of stock price for each ₹1 of annual profits, compared to ₹20 for Company A.

If both companies grow earnings at the same rate, Company B is the better bargain. The market has undervalued it relative to its profit generation capacity.

But here's the twist: What if Company A is profitable and stable, while Company B is in a competitive war and might lose half its earnings next year? Suddenly, Company A's P/E of 20 might be justified you're paying for stability and predictability. Company B's P/E of 10 might be a "value trap," where the price is cheap not because it's undervalued, but because the market suspects earnings will collapse.

This is why the P/E ratio alone isn't enough. It's a starting point for asking better questions: Why is one company's P/E higher than another's? What does the market see that I don't?

Trailing P/E vs. Forward P/E: The Battle Between Past and Future

When you look up a stock's P/E ratio, you'll often see two versions: trailing P/E and forward P/E. These two numbers tell completely different stories.

Trailing P/E uses the company's actual earnings from the last 12 months. It's backward-looking. It says: "This is what the company has already earned."

Forward P/E uses the company's expected earnings for the next 12 months. It's forward-looking. It says: "This is what the company will earn, assuming projections are correct."

Let's use a real example. Consider a fast-growing technology company:

• Current share price: ₹1,000

• Last 12 months' earnings per share: ₹50

• Trailing P/E: 1,000 ÷ 50 = 20

But the company is growing explosively. Analysts expect next year's earnings to jump to ₹100 per share:

• Expected earnings per share (next 12 months): ₹100

• Forward P/E: 1,000 ÷ 100 = 10

On trailing metrics, the stock looks expensive at 20x earnings. On forward metrics, it looks cheap at 10x earnings.

This is the trap many investors fall into. A stock might look "expensive" on current earnings but "cheap" on future earnings. The question becomes: Will the company actually deliver that earnings growth? If yes, you're buying a bargain. If no, you're overpaying for fantasy numbers.

This gap between trailing and forward P/E is where fortunes are made and lost. Growth stocks always have a lower forward P/E than trailing P/E because the market is pricing in that growth. But if the company misses those growth targets, the stock crashes because it was never justified on current earnings alone.

Real-World Example: Tesla's Extreme P/E Tells an AI Story

Let's look at Tesla, one of the most controversial stocks in the market.

As of June 2025, Tesla had a forward P/E ratio of 62. For context, traditional automakers like Ford trade at P/E of 8, and General Motors trades at P/E of 9. Tesla is trading at 6 to 8 times the valuation multiple of traditional automakers, despite being a much smaller company by revenue.

Why would investors accept such an extreme premium?

Because Tesla in 2025 isn't just a car company. The market is betting that Tesla's AI-driven autonomous driving technology (Full Self-Driving, or FSD) will revolutionize transportation and generate enormous profits. The company's gross margin improved to 18.5% in Q1 2025, up from 17.3% in Q4 2024, and FSD adoption surged 25%.

Tesla's P/E of 62 is the market saying: "We believe this company's earnings will explode 5-6 times over the next few years due to autonomy and AI breakthroughs." If Tesla delivers, investors buying at a P/E of 62 will look like geniuses. If the company disappoints and growth stalls, that same P/E will evaporate, and the stock will crash.

In June 2025, Tesla's stock surged 90% year-to-date, but volatility remained extreme. This wild volatility is the cost of paying a P/E multiple that far exceeds the broader market. You're betting on exponential future growth, and the stock price swings wildly as new evidence emerges about whether that growth will materialize.

Compare this to India's Reliance Industries, which trades at a P/E of around 27.6x as of December 2025. Reliance's P/E has ranged from 17.75x (March 2020, during COVID crash) to 29.35x (March 2022), with a five-year average of 25.19x. Reliance operates oil refineries, petrochemicals, telecom, and retail businesses—mature, capital-intensive businesses with predictable (though cyclical) earnings. A P/E of 27.6x is high, but it reflects a mature company with some growth prospects, not the exponential growth thesis embedded in Tesla's P/E of 62.

Or look at Indian IT giant TCS, which trades at P/E of 23.85x as of December 2025. TCS earns ₹12,131 crores in quarterly profits and has a massive market cap of ₹1,200,807 crores. A P/E of 23.85x reflects a high-quality, profitable business, but one growing slowly due to macro headwinds (weak IT spending globally, AI-driven budget reallocation from traditional IT services).

The Growth Premium: Why investors pay 7x more for Tesla earnings than Ford earnings.

The COVID Bubble: When P/E Becomes Detached from Reality

Between 2020 and 2021, the stock market experienced something extraordinary. The S&P 500's P/E ratio peaked at 38x in December 2020 the highest level since the year 2000 and the dot-com bubble. The last time it was anywhere close was the financial crisis of 2008-2009.

How did this happen?

When COVID-19 hit in March 2020, the Federal Reserve slashed interest rates to zero and launched massive stimulus programs. Corporate earnings initially crashed as lockdowns shut down businesses. But stock prices didn't fall as much as earnings fell. This meant the P/E ratio exploded to absurd levels.

The formula tells the story:

• March 2020: Stock prices fell 30-35%, but earnings fell even faster (50%+).

• Result: P/E ratio spiked despite the market being down massively.

By December 2020, after vaccines were announced and stimulus had pumped massive amounts of money into the economy, stock prices recovered and earnings stabilized. But the P/E remained at 38x because investors were pricing in a "new normal" of low interest rates forever, cheap money, and explosive growth ahead.

What actually happened? Interest rates didn't stay at zero. The Federal Reserve hiked rates from 0% to 5.25% between 2022 and 2024. This made bonds more attractive (a 5% savings account beats a 3% stock earnings yield). Earnings growth moderated. Companies that raised prices during inflation found consumer demand weakening.

The market corrected. P/E ratios compressed back to normal levels. Stocks that had soared 500-700% in the pandemic (Zoom, Peloton, Shopify) crashed 80-95% as investors realized they had been pricing in a permanent pandemic economy.

This is the danger of extreme P/E ratios: they represent not facts, but collective belief about the future. When the future doesn't arrive as expected, the P/E doesn't compress gradually—it collapses in a panic.

Why P/E Ratios Vary Across Sectors

Not all P/E ratios are created equal. Some sectors naturally trade at higher P/Es than others, and this reflects fundamental differences in business economics.

High P/E Sectors:

• Technology and Software: Often trade at 25-50x P/E because of high growth rates and pricing power.

• Pharmaceuticals: Trade at 15-30x P/E because of long product lifecycles and patent protection.

• e-Commerce and Digital Platforms: Trade at 20-60x P/E because of network effects and scaling.

Low P/E Sectors:

• Banking: Often trade at 10-20x P/E because earnings are directly tied to interest rate cycles and leverage constraints.

• Energy and Oil: Trade at 5-15x P/E because earnings are tied to commodity prices outside company control.

• Real Estate: Trade at 8-15x P/E because of leverage and regulatory constraints.

• Cyclical Manufacturing: Trade at 10-20x P/E because earnings swing with economic cycles.

Looking at India's market, we can see this clearly. As of December 2025:

• Hind. Unilever (Consumer Staples): P/E of 50.68x Investors pay ₹50 per ₹1 of earnings because it has pricing power, stable cash flows, and brand moat.

• Titan Company (Jewelry/Watches): P/E of 84.07x The highest on the market. Investors are betting on luxury consumption growth in India as incomes rise. A ₹84 valuation is extreme, but reflects India's growing middle class.

• HDFC Bank: P/E of 21.21x A high-quality bank with scale, but constrained by interest rate cycles and regulatory leverage limits. Much lower than consumer companies.

• SBI (State Bank of India): P/E of 11.35x A larger, older bank with less growth, trading at a discount to HDFC.

• ONGC (Oil & Gas): P/E of 7.97x Extremely low because oil earnings are commodity-dependent and unpredictable.

The market is assigning valuations based on each company's ability to grow earnings, the stability of those earnings, and how much leverage/cyclicality is embedded in the business.

The P/E and Interest Rates: An Invisible Hand

There's an invisible force that moves P/E ratios across entire markets: interest rates.

When interest rates rise, bonds become more attractive, and stock valuations compress (P/E ratios fall). Why? Because a investor can now earn 6% in a safe government bond, so stocks need to offer a higher earnings yield (lower P/E) to compete.

When interest rates fall, bonds become unattractive, and stock valuations expand (P/E ratios rise). Investors are forced into stocks and accept lower earnings yields.

This is why the P/E ratio is sometimes called a "rate ratio" it's as much about interest rates as it is about company fundamentals.

Consider what happened between 2020 and 2024:

• December 2020: Interest rates at zero. Bond yields near 1%. Stock investors had no alternative, so they accepted S&P 500 P/E of 38x.

• December 2024: Interest rates at 5%. Bond yields near 4.5%. Stock investors can get safe returns in bonds, so they demand lower P/E ratios. The S&P 500 P/E fell to 22-25x.

This is mechanical. It's not that companies got worse. It's that the required return on stocks increased as the risk-free rate increased.

This has profound implications for valuations in India. As of late 2025, India's 10-year government bond yield is around 6.5%. This influences what P/E ratios investors are willing to pay. If rates rise to 7-8%, P/E ratios will compress further. If rates fall to 5%, P/E ratios will expand.

The Inverse Relationship: Interest Rates vs. P/E Ratios See-Saw

How to Use P/E Ratios in Practice

The P/E ratio is not a buy-sell signal on its own. But it's a powerful diagnostic tool if you use it correctly.

1. Compare with the Market Average

The S&P 500 (U.S. market) has a long-term average P/E of 16-18x. The Nifty 50 (Indian market) has a long-term average P/E of around 20-22x. If a stock trades at half this P/E, it's either cheap or broken. If it trades at double, it's either expensive or exceptional.

2. Compare with Historical Averages

Look at where a stock's P/E has traded over the last 5-10 years. If it's trading at the high end of its range, it's expensive. At the low end, it's cheap. This is most useful for mature companies with stable earnings (banks, utilities, consumer staples).

For Reliance Industries, the P/E has ranged from 17.75x (March 2020 crash) to 29.35x (March 2022 peak). At 27.6x in December 2025, it's near the high end of its historical range, suggesting limited upside unless earnings accelerate.

3. Compare with Peers

Two companies in the same industry should have similar P/E ratios if they have similar growth prospects and profitability. If one is much cheaper, it's either a value opportunity or has hidden problems.

Indian banking is a good example: HDFC Bank trades at P/E of 21.21x, ICICI Bank at 18.27x, and SBI at 11.35x. All three are Indian banks, but HDFC has the best asset quality and growth, so commands a premium. SBI is older and slower, so trades at a discount. The P/E differences tell a story about which bank is highest quality.

4. Check the Forward P/E

If a stock's forward P/E is much lower than its trailing P/E, the market is expecting earnings to grow rapidly. If forward P/E is higher than trailing, the market is expecting earnings to decline. Either is useful information.

5. Calculate the Earnings Yield

Convert P/E to earnings yield and compare it to bond yields. If a stock has an earnings yield of 3% and a government bond yields 6%, the stock had better have exceptional growth prospects or you're being underpaid.

6. Look at the PEG Ratio

PEG = P/E Ratio ÷ Growth Rate

This compares a stock's P/E to its expected growth rate. A PEG of 1.0 means the stock is fairly valued relative to growth. Below 1.0 is cheap, above 1.0 is expensive. Tesla, with a P/E of 62 and expected growth of 20%+ annually, might have a PEG of 2.5-3.0, suggesting it's overvalued unless growth accelerates further.

The Ultimate Lesson: P/E Is a Story, Not a Number

At its core, the P/E ratio is the stock market's way of telling a story about the future. A low P/E says: "We don't believe in this company's growth, or we fear its earnings are temporary." A high P/E says: "We think this company will become far more profitable."

Apple might trade at P/E of 25-30x because investors believe its ecosystem and brand will generate enormous profits for decades. A commodity miner might trade at P/E of 8x because investors know commodity earnings are cyclical and unpredictable.

A startup with negative earnings (no P/E ratio at all) might have a ₹1 trillion valuation because investors are betting it will dominate a category worth ₹10 trillion in 20 years. An old, boring utility might have ₹1 billion in earnings but a ₹10 billion valuation (P/E of 10) because the earnings are stable, predictable, and dividended to shareholders forever.

The P/E ratio is not the truth. It's the market's collective hypothesis about the truth. And like all hypotheses, it can be spectacularly wrong. Investors who understand this distinction who see P/E not as a fact but as a belief—are the ones who can identify when the market's belief is too optimistic or too pessimistic.

In December 2020, the market's belief (S&P 500 P/E of 38x) was too optimistic. By mid-2022, reality had reasserted itself, and those who bought at 38x P/E had lost 30-40% of their investment.

In December 2024, with rates at 5%, growth slowing, and P/E ratios compressed to 22-25x, the question is: Is the market's new belief too pessimistic? That's the question every investor must answer for themselves.

The P/E ratio is the vocabulary. Understanding it is the first step. Using it wisely is the art.