What Is P/E Ratio and Why It Matters (Explained with a Small Grocery Shop Example)
If you’re new to investing, you’ve probably heard analysts on TV throw around the term “P/E ratio” like it’s common knowledge. It can feel intimidating, right? You see numbers, charts, and jargon, and it’s easy to feel confused.
When I first started learning investing, I used to think P/E ratio was just another fancy term for professionals. But then I compared it with a local grocery shop — and everything clicked.
Forget the complex charts for a minute. Let’s break down one of the most important concepts in investing using a simple story.
What Is P/E Ratio? (The Simple Definition)
In the simplest terms, the Price-to-Earnings (P/E) ratio is a formula.
P/E Ratio = Price per Share $\div$ Earnings per Share (EPS)
Let’s use an example:
If a company’s share price is ₹100 and it earns ₹10 per share annually (this is its EPS), its P/E ratio is 10 (₹100 / ₹10).
In plain English, this ratio tells you how much you are paying for every ₹1 of the company’s earnings. A P/E of 10 means you’re paying ₹10 for ₹1 of that company’s profit.
But what does that really mean? This is where our grocery shop comes in.
The Best Way to Understand P/E: Ravi’s Grocery Shop
Let’s imagine a fictional character, Ravi. Ravi owns a successful local grocery shop in his neighborhood.
- His shop is well-managed and makes a clear, consistent profit of ₹1,00,000 every year. (This is his “Earnings”).
Now, you’re interested in buying his business. You ask Ravi for the price.
- He says he wants ₹10,00,000 for it. (This is the “Price”).
So, what is the “P/E ratio” of Ravi’s grocery shop?
Price (₹10,00,000) / Earnings (₹1,00,000) = 10
This means you are willing to pay 10 times Ravi’s annual profit to own his business. If the profit stays exactly the same, it would take you 10 years to earn back your purchase price (this is also called the ‘payback period’).
This is exactly how the P/E ratio works for stocks. A stock’s “Price per Share” is the ‘price of the shop,’ and the “Earnings per Share” (EPS) is the ‘profit per share.’1
Why Does This Ratio Even Matter?
Okay, so it’s a number. Why should you care?
The P/E ratio is a powerful shortcut that helps you do two things:
- Gauge Valuation: It helps you guess if a stock is ‘expensive’ (overvalued) or ‘cheap’ (undervalued) compared to its own history or the market.
- Compare Companies: It’s a powerful tool for comparing companies in the same industry.
Let’s go back to our example. Imagine Ravi has a competitor, Suresh, who also owns a grocery shop. Suresh’s shop also earns ₹1,00,000 per year, but he is demanding ₹20,00,000 for it.
- Ravi’s P/E: 10
- Suresh’s P/E: 20 (₹20,00,000 / ₹1,00,000)
Suresh’s shop is twice as “expensive” as Ravi’s. You’re paying ₹20 for every ₹1 of profit, versus ₹10 for Ravi’s.
Here’s the twist: Does that mean Suresh’s shop is a bad deal? Not necessarily.
Maybe Suresh’s shop is in a brand-new, fast-growing part of town. Maybe he just launched a new online delivery service. Investors (you) might be willing to pay a higher P/E of 20 because you expect his profits to grow much, much faster than Ravi’s.
What the P/E Ratio Really Tells You (Market Sentiment)
The P/E ratio is like a thermometer for market sentiment. It shows how much confidence and expectation investors have in a company’s future.
- A High P/E: Investors are optimistic. They expect high future growth and are willing to pay a premium for it today. (Like Suresh’s shop).
- A Low P/E: Investors might be less optimistic. This could mean the company is undervalued (a hidden gem, like Ravi’s shop!). Or, it could mean the company is in trouble or has very slow growth prospects.
Think of it like paying for the brand, trust, and future potential — not just the present earnings.
So, What Is a “Good” P/E Ratio?
This is the most common question I get, and the honest answer is: there is no single magic number.
In India, the average P/E for the Nifty 50 (a collection of the top 50 companies) has often been around 20-25. So, anything in that range is often considered ‘average’ or ‘fairly valued.’
But a “good” P/E depends entirely on the industry.
- Tech Companies: Often have high P/Es (like 30, 40, or even 50+).2 Why? Because they are expected to grow very quickly.
- Utility Companies: (Like power or water companies). They usually have lower P/Es (like 10-15). Their earnings are stable and predictable, but they don’t grow very fast.
You can’t compare the P/E of a tech company to a power company. That’s like comparing the price of a mango to a potato—they’re just different. Always compare P/Es of companies in the same sector (Ravi vs. Suresh).
A Quick Bonus Insight: The “7% Rule” and PEG Ratio
Many long-term investors look for companies that can grow their earnings consistently. A common benchmark for decent growth is around 7-10% per year.
This is where a related concept, the PEG ratio, comes in. It’s one of my personal favorites because it adds growth to the P/E story.
PEG Ratio = P/E Ratio $\div$ Expected Earnings Growth Rate (%)
Let’s say a stock has a P/E of 20, but it’s expected to grow its earnings by 20% next year.
- Its PEG ratio is 1 (20 / 20).
Now, look at another stock with a lower P/E of 14, but its expected growth is only 7%.
- Its PEG ratio is 2 (14 / 7).
Many investors believe a PEG ratio of 1 is ideal—it means you’re paying a fair price perfectly in line with its growth. A PEG under 1 might suggest it’s a bargain.
Other Important Terms You’ll Hear
When you research P/E, you’ll see these related terms. Here’s what they mean in brief.
Price-to-Earnings Ratio for Stock Market
This is the average P/E of all the stocks in a major index, like the Nifty 50. It tells you if the entire market is generally feeling expensive or cheap.
Price-to-Earnings Ratio for Mutual Fund
A mutual fund holds many stocks.3 Its P/E is simply the weighted average P/E of all the stocks it owns. It tells you if the fund manager prefers high-growth (high P/E) or value (low P/E) stocks.
Price-to-Book (P/B) Ratio
This compares the stock’s price to its “book value” (what the company would be worth if it sold all its assets and paid its debts). It’s very useful for asset-heavy businesses like banks or manufacturing companies.
Earnings Per Share (EPS)
This is the most important one! It’s the ‘E’ in P/E. It’s the total profit of the company divided by the total number of shares. It’s the foundation of the whole calculation.
Key Takeaways: What We Learned
If you remember nothing else, remember these points:
- P/E = Price $\div$ Earnings per Share.
- It shows how much investors are willing to pay for every ₹1 of a company’s earnings.
- It helps you compare similar companies (Ravi vs. Suresh) in the same sector.
- A high P/E often means high growth expectations (or it’s overvalued).
- A low P/E often means slow growth (or it’s undervalued).4
- Never use P/E alone. Always look at the company’s debt, growth (PEG ratio), and industry.
My Final Thought
When I finally understood the P/E ratio through the simple grocery shop example, investing stopped feeling like gambling or guesswork. It started to feel logical.
You’re not just buying a ticker symbol; you’re buying a piece of a business. Once you start thinking like a business owner (like you’re buying Ravi’s shop), every number tells a story. The P/E ratio is just the first chapter.
Frequently Asked Questions (FAQ)
What is a good price-to-earnings ratio?
A P/E between 15–25 is often considered reasonable or average for the broader market. But a “good” P/E depends entirely on the industry and the company’s growth prospects.
What does P/E ratio tell you?
It shows how much investors are willing to pay for a company’s earnings. It’s a measure of market confidence and growth expectations.
What is the 7% rule in stock trading?
This can mean two things!
- Stop-Loss Rule: Many traders use it as a strict risk management rule: they sell a stock if it falls 7% from their purchase price to limit their losses.
- Growth Benchmark: In the context of P/E, it sometimes refers to a baseline for expected earnings growth. A company growing at 7% might be considered stable, and you’d compare its P/E to that growth rate (like we did with the PEG ratio).
What is EPS in simple terms?
EPS stands for Earnings Per Share.5 It’s the company’s total profit divided by the number of its shares. If a company made ₹1 crore in profit and has 10 lakh shares, its EPS is ₹10. It’s the ‘E’ in P/E.
Disclaimer: The information in this article is for educational purposes only and should not be considered financial advice. All investing involves risk. Always do your own research or consult a qualified financial advisor before making any investment decisions.