P/E Ratio

Measuring market performance. Explanation of P/E ratio.

P/E Ratio Price to Earnings ratio

What is the P/E Ratio? Description

The Price to Earnings ratio (P/E ratio) is a valuation ratio of a company's current share price compared to its per-share earnings. Discounted Cash Flow is a superior method to value a company. However sometimes investors prefer to use simpler methods.

Calculation of P/E Ratio. Formula

The P/E ratio is used for measuring market performance and can be calculated as:

P/E ratio calculation: Market Value per Share : Earnings Per Share normally for a twelve month period.

Often the P/E ratio is used, because it is so easy to grasp: If you buy stock at a P/E ratio of 10, say, this means it will take 10 years for the company's earnings to add up to your original investment - 10 years before you are paid back.

Example of Price to Earnings Ratio calculation

Take for example a company that earned $10M last year, and had given out 1 million shares in total. Earnings per share are $10. If that company's shares currently sell for $100 per share, it has a P/E ratio of 10. Stated differently, at this price, investors are willing to pay $10 for every $1 of last year's earnings.

Limitations of the P/E Ratio

The Price to Earnings ratio assumes that the corporation will be worth some multiple of its future earnings. This method has at least two drawbacks:

It is based on reported earnings, "accounting profits", which are not a good indicator of actual value creation for shareholders.
What multiplier should be used? The industry average? Often corrections are made based on: the expected growth of the company, the rate of return on new capital and the costs of capital (WACC)

Book: Steven M. Bragg - Business Ratios and Formulas : A Comprehensive Guide -

Book: Ciaran Walsh - Key Management Ratios -

P/E Ratio Forum

Recent User Comments

    			 
  			   Philippe - Belgium
  	       
  		     Average P/E ratio
  	  		 "At the moment, company earnings are at record levels. As a result, the current (high) stock prices and seemingly low P/E ratio's appear acceptable. But investors are advised to use average earnings over the past 10 years or so to calculate the P/E ratio, and compare that to the historical long-term average. This gives you a more realistic insight in the Price to Earnings ratio."
  			   
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