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)
Price
to Earnings Ratio = Market Price per Share / Earnings per Share
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.
Example.
If Company A shares are trading at $5/share and
most recent EPS is $0.2/share. The P/E ratio will be $5/$0.2 = 25x. 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”.
Conclusion
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
has been overlooked by the market i.e. undervalued. Sometimes, a low P/E ratio indicates a company is headed
over several issues or the company itself has warned a low earnings than
expected. 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
widely discussed problem in P/E ratio is that the denominator i.e. Earnings
figure, 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.
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