Price to Earnings Ratio (P/E Ratio)

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P/E ratio Definition

The price to earnings ratio (P/E ratio) is the ratio of market price per share to earning per share. The P/E ratio is a valuation ratio of a company's current price per share compared to its earnings per share. It is also sometimes known as “earnings multiple” or “price multiple”. Though Price-earning ratio has several imperfections but it is still the most acceptable method to evaluate prospective investments. It is calculated by dividing “Market Value per Share (P)” to “Earnings per Share (EPS)”. Market value of share can be taken from stock market or online and earning per share figure can be calculated by dividing net annual earnings to total number of shares (Net Annual Earnings/Total number of shares).

P/E ratio is a widely used ratio which helps the investors to decide whether to buy shares of a particular company. It is calculated to estimate the appreciation in the market value of equity shares.

Calculation (Formula)

It is calculated by dividing the current market price of a stock by its EPS. The formula for P/E ratio is as follows:

Price to Earnings (P/E) ratio

Here's an example to help illustrate this calculation:

Suppose a company has a current market price per share of $50 and earnings per share of $5.

P/E ratio = $50 / $5 = 10

Therefore, the P/E ratio for this company is 10. This means that investors are willing to pay $10 for every dollar of earnings that the company generates. The P/E ratio can be used to compare the valuation of different companies in the same industry or sector, and it is often used as a measure of the market's perception of a company's growth potential and future earnings prospects.

The price to earnings ratio can also be calculated with the help of following formula:

Price to Earnings Ratio = Market Capitalization / Earnings after Taxes and Preference Dividends

The P/E ratio tells how much the market is willing to pay for a company’s earnings. A higher P/E ratio means that the market is more willing to pay for the earnings of the company. Higher price to earnings ratio indicates that the market has high hopes for the future of the share and therefore it has bid up the price. On the other hand, a lower price to earnings ratio indicates the market does not have much confidence in the future of the share.

The average P/E ratio is normally from 12 to 15 however it depends on market and economic conditions. P/E ratio may also vary among different industries and companies. P/E ratio indicates what amount an investor is paying against every dollar of earnings. A higher P/E ratio indicates that an investor is paying more for each unit of net income. So P/E ratio between 12 to 15 is acceptable.

For example, if company A shares are trading at $50/share and most recent EPS is $2/share. The P/E ratio will be $50/2$ = $25. This indicates that the investors are paying $25 for every $1 of company’s earnings. Companies with no profit or negative earnings have no P/E ratio and usually written as “N/A”.  

Norms and Benchmarks

A higher P/E ratio may not always be a positive indicator because a higher P/E ratio may also result from overpricing of the shares. Similarly, a lower P/E ratio may not always be a negative indicator because it may mean that the share is a sleeper that has been overlooked by the market. Therefore, P/E ratio should be used cautiously. Investment decisions should not be based solely on the P/E ratio. It is better to use it in conjunction with other ratios and measures.  

The most obvious and widely discussed problem in P/E ratio is that the denominator considers non cash items. Earnings figure can easily be manipulated by playing with non cash items, for example, depreciation or amortization. If it is not manipulated deliberately, earnings figure is still affected by non cash items. That is why a large number of investors are now using “Price/Cash Flow Ratio” which removes non cash items and considers cash items only.

It is normally assumed that a low P/E ratio indicates a company is undervalued. It is not always right as this may be due to the stock market assumes that the company is headed over several issues or the company itself has warned a low earnings than expected. Such things may lead to a low P/E ratio.

How to compare two companies with different Price to Earnings (P/E) ratio?

When comparing two companies with different Price to Earnings (P/E) ratios, it's important to consider several factors that can affect their ratios, such as industry, growth prospects, and risk profile. Here are a few ways to compare companies with different P/E ratios:

  1. Use P/E ratios relative to their peers: Compare the P/E ratios of each company to other companies in the same industry or sector. If Company A has a higher P/E ratio than Company B, but both are in the same industry, it may indicate that Company A is expected to grow at a faster rate or has a better risk profile than Company B.

  2. Look at historical trends: Compare the current P/E ratios of each company to their historical averages. If Company A has a higher P/E ratio than its historical average while Company B has a lower P/E ratio than its historical average, it may indicate that Company A is currently overvalued and Company B is currently undervalued.

  3. Use forward P/E ratios: Consider the forward P/E ratio, which is calculated using the expected earnings per share for the upcoming year. This can provide a better indication of a company's future growth prospects. If Company A has a higher forward P/E ratio than Company B, it may indicate that Company A is expected to grow at a faster rate in the future.

  4. Consider other valuation metrics: Look at other valuation metrics such as Price to Sales (P/S), Price to Book (P/B), or Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA) to get a more complete picture of the relative value of each company.

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