P/E Ratio (Price to Earnings Ratio)

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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

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

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