 # P/E Ratio (Price to Earnings Ratio)

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## 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 (49 members)  Forum - P/E Ratio

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