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
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:
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