To invest in stocks you need to understand a few terminologies about valuation. How do you figure out if the stock price of a company is overvalued or undervalued? There are many ways to do this but the most often quoted ratio is the P/E ratio, or the Price to Earnings Ratio.

But before you have that, you should understand EPS – or Earnings Per Share. Every company releases quarterly results in which it announces its profits, total equity capital and basic and diluted Earning Per Share. This means Net Profit divided by total number of shares. The idea here is – if a company has 10,000 shares in total, and the company makes 500,000 in profit (in a quarter), the EPS for that quarter is Rs. 50. If you “annualise” that EPS – meaning prorate it over a year, the EPS would be Rs. 200.

But of course the company may go through quarterly earnings changes, so you don’t just multiple quarterly earnings by four. What you do is to take the LAST FOUR QUARTERS EPS, and add them up to get the “trailing four quarter EPS”. This is the Trailing EPS.

Aside: How you get these figures is to go to http://www.nseindia.com and look for the last four quarter results. For instance this is the BHEL page, which has links to the last eight to twelve quarters of results. You can add them up manually, or visit sites such as moneycontrol.com or myiris.com to get a pre-added set.

Now, the past is the past. It is not the future, right? So some analysts will check the company and release estimates of how much the EPS will be for the next four quarters. This is called the “forward EPS“.

P/E Ratio: How does the EPS help you? It does not. It’s not reflective of anything in itself. You must take the stock price and divide it by the EPS, to get the P/E ratio. The P/E ratio, for BHEL for example is about 26 for the trailing four quarter EPS. If you consider that it’s last quarter earnings will be the same over the next four quarters, the forward EPS is 108, and the forward P/E is about 22. (at todays price of 2350)

The P/E ratio (also called the “Earnings Multiple”) needs to be compared in the same sector that a company is in. P/E of a sector is usually at similar levels – for instance, tech companies have P/E of around 30-35, PSU banks 5-10, Private banks 22-25 and so on. BHEL might sound high at 26 – but other heavy engineering companies like Praj Industries have an even higher P/E.

Other factors can influence P/E – visibility of earnings (longer the better), order book, brand name etc. What people generally say is that the P/E should reflect the percentage growth in earnings of a company. That means if BHEL gets a P/E of 26, it should grow at 26% (net profits) – now the most recent quarter has shown much more than that – 45%+ so the company is still undervalued by that measure. Forward growth looks robust, with an order book of more than 30,000 cr. and going forward, I would expect that even if the P/E is lowered (because of a correction), BHEL’s earnings growth itself would cover it and the stock price will sustain itself.

There’s one more thing called “diluted EPS”. When a company issues stock options, or raises capital using convertible debentures, the number of shares issued will increase when the stock options are exercised or when the debentures are converted. Eventually this means an increase in the number of shares, that is sure to happen, it just hasn’t happened yet. So the company needs to release the “diluted EPS” meaning the total known number of shares that must be used for the EPS calculation. Always use diluted EPS when making any P/E comparisons.

Note here that forward P/E calculations can be based on unknown numbers – every analyst will have his or her own set of numbers. Always take an average of multiple numbers when you analyse estimates.