Price Earnings Ratio (P/E)
This is a complete guide on how to calculate PE ratio with detailed analysis, interpretation, and example. You will learn how to use its formula to determine if a company is currently cheap or expensive.
Definition - What is PE Ratio and How It is Used?
The price earnings ratio, or P/E ratio, is commonly used by investors to figure out what price the market is willing to pay for shares of a particular company’s stock.
More specifically, this ratio describes a stock’s market value in relation to the amount of earnings it’s generating.
Why is PE ratio so important?
By comparing a firm’s current earnings per share (EPS), with its current market price per share, the price to earnings ratio can help you to evaluate what a stock is currently worth, and can also help you to predict what it could be worth based on future earnings.
When a business is expected to increase its earnings over the long-term, this is obviously seen as a positive attribute, since it means there will be more cash available to fund higher investor dividends.
Similarly, if the PE ratio tells you that a stock is currently undervalued in the marketplace, and is selling at a price well below its intrinsic worth, it may mean that share prices are set to increase, as investor demand eventually brings the stock back in line with its true value.
So how is PE ratio calculated? To find the price-earnings ratio for a given company, you would use the following formula:
Price to Earnings Ratio = Market Value per Share / Earnings per Share
Using this calculation allows you to determine the trading value of a company’s stock for any given reporting period.
The trailing P/E ratio is what’s revealed when you use the most recent earnings per share figure from a firm’s last reporting period, while a leading P/E ratio is created when the earnings per share figure used is based on future predictions.
PE Ratio Calculator
So now you know the PE ratio formula, now let's consider this example so you can understand exactly how to calculate price earnings ratio in real life.
Assume that you are investing in Company JJ which has most recently reported an Earnings per Share (EPS) of $10 and its stock is currently selling at $100 a share.
By comparing the earnings per share with the current price of Company JJ’s stock, you can easily calculate the firm’s PE ratio, like so:
The result shows that the earnings per share equals 1/10 of the current share price.
Interpretation & Analysis
Now we're done with the P/E ratio calculation, let's find out how to use this ratio to determine if a company is cheap or expensive.
So what is a good PE ratio?
The higher a company’s price earnings ratio, the more money investors are paying for each dollar of that company’s earnings.
In other words, if a business has a PE ratio of 10, as in the example of Company JJ, it means that investors are willing to pay 10 times the value of Company JJ’s current earnings per share, to own that stock.
A rising ratio is usually an indication that the market believes in a company’s ability to increase its future earnings.
You should recognize, however, that if a firm’s price to earnings ratio is already quite high, its earnings picture may continue to improve, but there’s less chance that its stock price will continue to increase.
At the other end of the spectrum, a lower price to earnings ratio tells you that the market doesn’t currently expect much from a business in terms of any significant earnings increases.
Cautions & Further Explanation
Making use of the price to earnings ratio can be a tricky task if the shares of the business you’re evaluating have been fluctuating severely in price over the short-term.
This is often the case whenever there are rumors involving a company’s management, financial strategy, or future performance.
News items and speculation can have a huge impact on a firm’s perceived value at any given point in time, and will affect its price earnings ratio as a result.
You should also bear in mind that many market factors affect entire industries as a whole.
Rather than simply accepting a promising or less promising PE ratio at face value, you would be wise to compare potential investments with other companies in the same industry.
It's commonly believed that the use and application of this ratio is now out of date, so you should avoid using this ratio alone.