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DEFINITION of 'Price-Earnings Ratio - P/E Ratio'

The price-earnings (P/E) ratio is a valuation metric that compares a company's share price to its per-share earnings. It is calculated as market share price divided by earnings per share. A higher P/E ratio suggests that investors expect higher future earnings growth. P/E ratios should only be used to compare companies within the same sector, as valuations vary widely between sectors. Additionally, debt levels and accuracy of earnings estimates can impact P/E ratios. The P/E ratio provides a limited view and should be considered alongside other factors in investment decisions.

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89 views

DEFINITION of 'Price-Earnings Ratio - P/E Ratio'

The price-earnings (P/E) ratio is a valuation metric that compares a company's share price to its per-share earnings. It is calculated as market share price divided by earnings per share. A higher P/E ratio suggests that investors expect higher future earnings growth. P/E ratios should only be used to compare companies within the same sector, as valuations vary widely between sectors. Additionally, debt levels and accuracy of earnings estimates can impact P/E ratios. The P/E ratio provides a limited view and should be considered alongside other factors in investment decisions.

Uploaded by

peter
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Price-Earnings Ratio - P/E Ratio

DEFINITION of 'Price-Earnings Ratio - P/E Ratio'


The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its
current share price relative to its per-share earnings.
The price-earnings ratio can be calculated as:
Market Value per Share / Earnings per Share
For example, suppose that a company is currently trading at $43 a share and its earnings over the
last 12 months were $1.95 per share. The P/E ratio for the stock could then be calculated as
43/1.95, or 22.05.
EPS is most often derived from the last four quarters. This form of the price-earnings ratio is
called trailing P/E, which may be calculated by subtracting a companys share value at the
beginning of the 12-month period from its value at the periods end, adjusting for stock splits if
there have been any. Sometimes, price-earnings can also be taken from analysts estimates of
earnings expected during the next four quarters. This form of price-earnings is also called
projected or forward P/E. A third, less common variation uses the sum of the last two actual
quarters and the estimates of the next two quarters.

BREAKING DOWN 'Price-Earnings Ratio - P/E Ratio'


In essence, the price-earnings ratio indicates the dollar amount an investor can expect to invest in
a company in order to receive one dollar of that companys earnings. This is why the P/E is
sometimes referred to as the multiple because it shows how much investors are willing to pay per
dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the
interpretation is that an investor is willing to pay $20 for $1 of current earnings.
In general, a high P/E suggests that investors are expecting higher earnings growth in the future
compared to companies with a lower P/E. A low P/E can indicate either that a company may
currently be undervalued or that the company is doing exceptionally well relative to its past
trends. When a company has no earnings or is posting losses, in both cases P/E will be expressed
as N/A. Though it is possible to calculate a negative P/E, this is not the common convention.
The price-earnings ratio can also be seen as a means of standardizing the value of one dollar of
earnings throughout the stock market. In theory, by taking the median of P/E ratios over a period
of several years, one could formulate something of a standardized P/E ratio, which could then be
seen as a benchmark and used to indicate whether or not a stock is worth buying.

Limitations of 'Price-Earnings Ratio - P/E Ratio'

Like any other metric designed to inform investors as to whether or not a stock is worth buying,
the price-earnings ratio comes with a few important limitations that are important to take into
account, as investors may often be led to believe that there is one single metric that will provide
complete insight into an investment decision, which is virtually never the case.
One primary limitation of using P/E ratios emerges when comparing P/E ratios of different
companies. Valuations and growth rates of companies may often vary wildly between sectors due
both to the differing ways companies earn money and to the differing timelines during which
companies earn that money. As such, one should only use P/E as a comparative tool when
considering companies within the same sector, as this kind of comparison is the only kind that
will yield productive insight. Comparing the P/E ratios of a telecommunications company and an
energy company, for example, may lead one to believe that one is clearly the superior
investment, but this is not a reliable assumption.
An individual companys P/E ratio is much more meaningful when taken alongside P/E ratios of
other companies within the same sector. For example, an energy company may have a high P/E
ratio, but this may reflect a trend within the sector rather than one merely within the individual
company. An individual companys high P/E ratio, for example, would be less cause for concern
when the entire sector has high P/E ratios.
Moreover, because a companys debt can affect both the prices of shares and the companys
earnings, leverage can skew P/E ratios as well. For example, suppose there are two similar
companies that differ primarily in the amount of debt they take on. The one with more debt will
likely have a lower P/E value than the one with less debt. However, if business is good, the one
with more debt stands to see higher earnings because of the risks it has taken.
Another important limitation of price-earnings ratios is one that lies within the formula for
calculating P/E itself. Accurate and unbiased presentations of P/E ratios rely on accurate inputs
of the market value of shares and of accurate earnings per share estimates. While the market
determines the value of shares and, as such, that information is available from a wide variety of
reliable sources, this is less so for earnings, which are often reported by companies themselves
and thus are more easily manipulated. Since earnings are an important input in calculating P/E,
adjusting them can affect P/E as well. (See also, How can the P/E ratio mislead investors?)

Things to Remember

Generally a high P/E ratio means that investors are anticipating higher growth in the
future.

The average market P/E ratio is 20-25 times earnings.

The P/E ratio can use estimated earnings to get the forward looking P/E ratio.

Companies that are losing money do not have a P/E ratio.

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