P/E Ratio (Price to Earnings Ratio)

Knowledge Center

Measuring market performance. Explanation of P/E 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:

1. It is based on reported earnings, "accounting profits", which are not a good indicator of actual value creation for shareholders.
2. 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 -

Special Interest Group - P/E Ratio Special Interest Group (50 members)

Forum - P/E Ratio   Here you will find interesting and educational discussions.   Why Using Average P/E Ratio is More Realistic During favorable economic times (boom), company earnings are...           High PE Ratio Means What? A Good Stock? (1 reactions) What is the meaning if Company A has been trading at a highe...           What is the Beta of a Stock? (1 reactions) Before we're investing in a stock, we not only consider the ...           What is the meaning of X in PE Ratio? (1 reactions) Sometimes PE Ratio is given as 12.9x... What does "x" mean?...           Conflict of Interest of Management Buy Out If management is allowed to buy out the companies they work ...           When is Stock Overbought and Oversold? WHEN IS STOCK OVERBOUGHT? "Overbought" refers to a conditio...           Relevance of PE Ratio for CEO What is the importance of the P/E ratio to the CEO of a comp...

Best Practices - P/E Ratio Here you will find the most valuable ideas.

Expert Tips - P/E Ratio Here you will find high-quality advice from experts.   What are the Indicators of High Quality of Earnings? Analyzing Reported Earnings...       What is the Degree of Management Discretion or Manipulation? Analyzing Reported Earnings...

Resources - P/E Ratio Here you will find powerpoint presentations, micro-learning videos and further information sources. Financial Statement Analysis | Ratio Analysis Ratio Analysis, Finanical Statement Analysis...   Business Valuation | Company Valuation | Firm Valuation Business Analysis, Company Analysis | Firm Analysis...   3 Minute Introduction to Financial Ratio Analysis: Why do it and What are the Main Types? Types of Financial Ratios, Financial Ratio Analysis, Financial Ratio Types...   P/E Ratio Diagram Analyzing Stock Performance...     News about P/e Ratio         News about P/e Limitations         Videos about P/e Ratio         Videos about P/e Limitations         Presentations about P/e Ratio         Presentations about P/e Limitations         Books about P/e Ratio         Books about P/e Limitations         More about P/e Ratio         More about P/e Limitations

Compare with the P/E Ratio: PEG Ratio  |  Market Value Added  |  EBIT  |  EBITDA  |  Economic Margin  |  Return on Equity  |  TSR  |  PRVit

Return to Management Hub: Decision-making & Valuation  |  Finance & Investing

More Management Methods, Models and Theory