Price/Earnings Ratio (P/E Ratio)

Price/Earnings Ratio (P/E Ratio)

The Price/Earnings Ratio, also Price-to-Earnings Ratio, or shortly the P/E ratio, is a valuation metric of a company's current share price compared to its per-share earnings. The P/E ratio looks at the relationship between the stock price and the company’s earnings.

The P/E ratio is the most common measure of how expensive a stock is. People use it so popularly mainly because it is so simple.

The P/E ratio does not work very well as a timing device, but it can provide some idea of whether the market is "cheap" or "expensive".

How P/E is calculated?

The price/earnings ratio or the P/E ratio is equal to a stock's market capitalization divided by its after-tax earnings over a 12-month period.

               Market Value per Share
P/E ratio = ----------------------------
              Earnings per Share (EPS)

The Earnings per Share (EPS) is usually taken from the last four quarters. Then, the P/E ratio is called trailing P/E.

Earnings per Share (EPS) can sometimes be taken from the estimates of earnings expected in the next four quarters. Then, the P/E ratio is called projected or forward P/E.

In some cases, P/E ratio can be calculated by taking the sum of the last two actual quarters and the estimates of the next two quarters.

What are the implications of high P/E ratio?

In general, the higher the P/E ratio, the more the market is willing to pay for each dollar of annual earnings. Investments in stock of companies with high P/E ratios are more likely to be considered risky because a high P/E ratio signifies high expectations. Some investors read a high P/E as an overpriced stock.

Investments with low P/E ratios are chaper and less risky.

The P/E is the most popular metric of stock analysis, but it is important that it must not be blindly considered alone. It is one of many metrics that give the picture.

What does a low P/E ratio mean?

A low P/E may indicate a low confidence in the company by the market.

However, it could also mean that the stock just has been overlooked by the market and represents a potential for gain. Some investors made their fortunes spotting these companies some times called diamonds in the rough.

What is the right P/E?

There is no good answer to this question. That is because the answer depends on perception. What is a good price for shoes? Someone will buy shoes for $30 while someone else will consider $35 a good deal too based on the information that is available to him or her.

The "right" P/E ratio depends on the investor's willingness to pay for earnings.

The more an investor is willing to pay, which means he or she believes the company has good long term prospects over and above its current position, the higher the "right" P/E is for that particular stock.

Nevertheless, the P/E ratio can provide some clue about whether the market is "cheap" or "expensive". See the S&P500 historical values:

Price Earnings Ratio (P/E Ratio) S&P 500

P/E Ratio: apples to apples

When comparing investments, it is necessary to keep in mind what we are comparing. Comparing P/E ratios is most valuable for companies within the same industry.

For example, companies in the IT industry tent to have higher P/E than companies in the food industry. That is because IT industry is believed to have higher expected margins and be more profitable (but also more risky though), thus investors are willing to pay more for what they hope they will get.

Alternative names

Also sometimes known as price multiple, earnings multiple, or price-to-earnings ratio.


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