Price to Earnings ratio or P/E ratio

Hi  there ..

In the last post I discussed about earnings and earnings per share. You learnt that Earnings per share is useful to compare two or more companies of the same category and industry. In this article we will look into a more important ratio called the P/E ratio. That’s the Price / Earnings ratio more commonly called the P/E ratio. The P/E Ratio is  a widely used ratio for valuing shares prices. It also know by different term such as P/E multiple, earnings ratio , Price earnings ratio, P/E ratio etc..

WHAT IS IT?

The ‘P’ in the formula stands for the market price of the share.The “E” in the formula stands for the Earnings per share. If you see a stock trading at  50 per share on the market, and that stock had an EPS (earning per share) of  2.50, then according to this  formula, the P/E Ratio of this stock is 20.

HOW TO CALCULATE P/E

The P/E looks at the relationship between the stock price and the company’s earnings. You calculate the P/E by taking the share price and dividing it by the company’s EPS as shown in the above example.

WHAT DOES THE P/E TELL YOU ?

The P/E gives you an idea of what the market is willing to pay for a share of company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stock’s future and has bid up the price.

Conversely, a low P/E may indicate a “vote of no confidence” by the market or it could mean this is a sleeper that the market has overlooked. Known as value stocks, many investors made their fortunes spotting these “sleepers” before the rest of the market discovered their true worth.

WHAT IS THE RIGHT P/E?

There is no correct answer to this question, because part of the answer depends on your willingness to pay for earnings. The more you are willing to pay, which means you believe the company has good long term prospects over and above its current position, the higher the “right” P/E is for that particular stock in your decision-making process. Another investor may not see the same value and think your “right” P/E is all wrong.

MORE TIPS ON P/E

  • If a stock has a P/E of 15, that means the market is willing to pay 15 times its earnings for the stock. For this reason, P/E is sometimes referred to as a multiple. In the above example, the stock has a multiple of 15. Also denoted as 15x .
  • Companies with good growth potential will have a higher P/E because investors are willing to pay a premium for future profits.
  • High-risk companies will typically have low P/Es, which means the market is not willing to pay a high price for risk.

IS THE P/E FORMULA PERFECT TO VALUE STOCKS?

Unfortunately, P/E alone cannot be used as a single measure to value stocks.  The reason is that an individual company’s earnings figure  can be skewed by accounting abnormalities which may temporarily inflate or deflate the actual earnings. A low P/E does not necessarily mean a stock is cheap and l a high P/E doesn’t mean a stock is expensive! You have to compare apples to apples. You have to put a stock’s P/E ratio into the proper context.So you cannot make a buy or sell decision strictly on P/E, but it can be used to get greater insights into a sector or stock price.

  • Different industries have different P/E  ratio ranges that are considered normal. For example in the recent years of IT boom, information technology companies had high P/E ratios compared to other sectors.
  • P/E ratios are available are available sector wise. This helps in finding out which sectors are more expensive at a particular point of time.To know when a sector is overpriced,   the average P/E ratio of all of the companies in the industry is compared to the historical average. If the average climbs far above the historical average, you get the hint that the sector as a whole is overpriced.
  • You can use the P/E  ratio to compare the prices of companies in the same sector. For example, if company A and company B are both selling for 50 per share, one might be far more expensive than the other depending upon the underlying profits and growth rates of each stock.

    That’s about P/E ratio. In my next post , i will detail more about the types of P/E ratio and some more tips on how to use it.

    Bye for now !

You may like these posts:

  1. Understanding Earnings Per Share (or EPS)
  2. Introduction to financial ratios

2 Responses to “Price to Earnings ratio or P/E ratio”

JAY SINGH

September 14, 2015 at 7:54 am

Hi Victor,
Gr8 work u r doing.
A big thanks to you for making this I am a regular visitor to this site & try to read all topics .The beauty of your writing is that you make us understand these so called difficult topics in such a simple word.

Nsgaraju

January 25, 2016 at 5:17 am

Its so simple. Thanks

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