The P/E Ratio, Deeper: Earnings, Estimates, and What a Good Multiple Looks Like

If you've read Part 1, you already know the core insight: price alone tells you nothing. The P/E ratio — price divided by earnings — is what tells you whether a stock is actually cheap or expensive relative to what the business earns.

But that naturally raises a few questions. Where do those earnings come from? Are they reliable? And when someone says a stock has a "good" P/E, what does that actually mean?

This post answers all of that — including the uncomfortable question of what happens when a company lies about its earnings.

📝 Note: This post was written with the assistance of AI. The content reflects my personal learning and understanding and should not be taken as professional advice. Please do your own research and due diligence before acting on anything written here.

💰 Where Do Earnings Come From?

When we talk about "earnings" in the P/E ratio, we mean net profit — what's left over after the company has paid for everything: salaries, rent, raw materials, interest on debt, taxes, all of it.

Every publicly listed company is legally required to publish financial statements on a regular basis — quarterly and annually. These reports include an income statement (also called a profit and loss statement), which shows you exactly how the company went from total revenue down to net profit.

A simplified version looks like this:

That net profit number is then divided by the total number of shares outstanding to get Earnings Per Share (EPS):

$EPS = \frac{\text{Net Profit}}{\text{Number of Shares Outstanding}}$

And then:

$P/E = \frac{\text{Share Price}}{\text{EPS}}$

You don't need to calculate this yourself — every brokerage platform and financial site (Zerodha, Groww, NSE India, Screener.in, Yahoo Finance) displays it. But knowing what's underneath the number matters enormously, especially when you get to the next section.

🕰️ Trailing vs Forward P/E — Which Earnings Are We Even Talking About?

Here's something that trips up a lot of beginners: when you look up a P/E ratio, it's not always obvious which earnings are being used. There are two main versions:

Trailing P/E is grounded in reality. The earnings already happened. The numbers are audited and published. It's backward-looking, but it's factual.

Forward P/E uses analyst predictions about what the company will earn over the next year. This makes it more relevant for fast-growing companies — after all, you're buying the future, not the past — but it comes with a catch: forecasts can be wrong. Sometimes very wrong.

A stock might look cheap on a trailing P/E of 30x but expensive on a forward P/E of 50x — meaning analysts expect earnings to fall significantly. Or the reverse: a trailing P/E of 40x with a forward P/E of 20x means analysts expect earnings to nearly double.

Neither version is better in every situation. What matters is that you know which one you're looking at and what assumptions are baked into it.

Rule of thumb: Use trailing P/E for stability and fact-checking. Use forward P/E to understand market expectations — and then ask yourself whether those expectations are realistic.

🤔 But Wait — What If the Company Lies About Its Earnings?

This is one of the sharpest questions you can ask, and it deserves a real answer.

Companies can and do manipulate their reported earnings. Not always through outright fraud — often through perfectly legal accounting choices that paint a rosier picture than reality. This is sometimes called earnings management, and it's more common than most people realise.

Some of the ways it happens:

Revenue recognition timing. A company can choose when to "book" a sale. By pulling future sales into the current quarter, they can make earnings look better right now — even if nothing has really changed in the business.

Depreciation choices. Companies have some flexibility in how they account for the wear and tear on their assets. Slower depreciation = higher reported profit, at least in the short term.

One-time items. A company might exclude a large cost by calling it "non-recurring" — meaning it claims this expense won't happen again. Sometimes that's true. Sometimes the same "one-time" charge appears every single year.

Outright fraud. Rare, but it happens. Enron, Satyam, Wirecard — all companies that reported fabricated earnings for years before collapsing.

So Does This Make the P/E Ratio Useless?

No — but it does mean you shouldn't use it blindly. A few things that help:

Look at cash flow alongside earnings. A company can manipulate its reported profit much more easily than it can manufacture actual cash. If a company reports strong earnings but consistently generates weak or negative operating cash flow, that's a red flag worth investigating. Earnings and cash flow should broadly move together over time.

Check for consistency. One great quarter surrounded by mediocre ones is a different story from steadily growing earnings over several years. The longer the track record, the harder it is to sustain manipulation.

Compare to industry peers. If every competitor in the industry reports a P/E of 15–20x and one company is reporting a P/E of 8x with unusually high profit margins, ask why. Sometimes it's a genuine bargain. Sometimes the numbers are too good to be true.

Read the auditor's notes. Auditors flag concerns in the fine print of financial statements. It's dry reading, but a qualified audit opinion or a change in auditors is worth paying attention to.

The honest truth: No single ratio protects you from fraud. But combining the P/E with cash flow analysis, trend consistency, and a healthy dose of scepticism gets you a long way.

📊 What Even Is a "Good" P/E?

This is where a lot of beginner resources fall short — they'll tell you that a P/E below 15 is cheap and above 25 is expensive, as if those numbers mean the same thing across every company, industry, and time period. They don't.

Context is everything. Here's why:

Context 1: Industry Matters Enormously

Different industries have structurally different P/E ranges, and comparing across them is like comparing samosa prices to flight ticket prices — they're not the same category.

A software company at 60x P/E might be perfectly reasonable. A utility company at 60x would be shockingly expensive. You have to know the baseline for the industry you're looking at.

Context 2: Growth Changes Everything

A company growing earnings at 40% per year deserves a higher P/E than one growing at 5% — because you're paying for the future earnings stream, not just today's profits.

This is why high-growth companies like the early versions of Infosys or today's fast-scaling startups often trade at what look like sky-high multiples. The market is pricing in years of future earnings growth. Whether that growth actually arrives is the bet you're making.

Context 3: Interest Rates Affect What P/E Is "Fair"

This one is slightly advanced, but worth flagging. When interest rates are low, investors accept lower returns from stocks — which pushes P/E ratios up across the board. When rates are high, safer investments (like bonds or fixed deposits) become more attractive, which pulls P/E ratios down.

This is part of why market-wide P/E ratios in the 2010s looked elevated compared to historical averages — interest rates were near zero for much of that decade. It wasn't purely irrational exuberance. The environment changed what a "fair" valuation looked like.

✏️ Key Takeaways

• Earnings come from net profit, which every listed company must publish quarterly and annually.
• Trailing P/E uses past earnings (factual). Forward P/E uses estimated future earnings (useful but uncertain). Always check which one you're looking at.
• Earnings can be manipulated — legally through accounting choices, and illegally through fraud. Cross-check with operating cash flow and long-term consistency.
• There is no universal "good" P/E. What's cheap in one industry can be wildly expensive in another. Always compare within context: same industry, same time period, same company history.
• Growth and interest rates both affect what P/E makes sense. A high P/E on a fast-growing company is not automatically expensive.

Here's the reframe: the P/E ratio is not an answer — it's the beginning of a question. It tells you what the market is pricing in. Your job is to decide whether that pricing makes sense.