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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Information Sources Various sources of information regarding the P/E Ratio. Here you will find powerpoints, videos, news, etc. to use in your own lectures and workshops. Financial Statement Analysis | Ratio Analysis Ratio Analysis, Finanical Statement Analysis This presentation provides insights in Financial statement and ratio analysis, and includes the following sectios: 1. F... Business Valuation | Company Valuation | Firm Valuation Business Analysis, Company Analysis | Firm Analysis This presentation elaborates on the valuation and analysis of companies and include the following sections: 1. Company ... 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 Why financial ratio analysis? 1. To compare the financial health of (similar) companies (which one is doin... P/E Ratio Diagram Analyzing Stock Performance Download and edit this 12manage PowerPoint graphic for limited personal, educational and business use. Republishing in ...

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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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