What is a Price-to-Earnings Ratio (P/E Ratio)? – Formula, Examples

What is a Price-to-Earnings Ratio (P/E Ratio)? – Formula, Examples

Have a Friend who would love this ? Spread the Love 💙💙

The price-earnings ratio, also known as P/E ratio, is used for valuing companies and to find out whether they are overvalued or undervalued.

The objective of any investor ought to be to get the best possible deal available when buying a stock. The better the deal, the higher the potential for profit.

When professionals use fancy words or lingo, it can scare us silly. But fancy lingo doesn’t mean that something is complicated and out of the spectrum of understanding.

When you actually research it, most terms and “formulas” in the investment world are actually pretty simple. The same can be said of P/E ratios.

In this regard, both a company’s Price Earnings ratio and stock price can offer great understanding into whether the time is on the whole correct to purchase a given stock.

Let us discuss in detail about what does Price-to-Earning Ratio means? What Is the relationship between P/E Ratio and Stock Price? What is the P/E formula? Why the P/E Ratio Is Important? What is a good P/E Ratio?

What is a Price-to-Earning Ratio?

The Price to Earnings Ratio is the relationship between a company’s stock price and earnings per share (EPS).

It is a popular ratio that gives investors a better sense of the value of the company. 

The Price-to-Earning ratio shows the expectations of the market and is the price you must pay per unit of current earnings (or future earnings).

The price-earnings ratio relates a company’s share price to its earnings per share.

Companies that have no earnings or that are losing money do not have a P/E ratio since there is nothing to put in the denominator.

A high P/E ratio could mean that a company’s stock is over-valued, or else that investors are expecting high growth rates in the future.

P/E Ratio Formula:

Price Earnings Ratio (P/E) Infographic

P/E = Stock Price Per Share / Earnings Per Share

or

P/E = Market Capitalization / Total Net Earnings

or

Justified P/E = Dividend Payout Ratio / R – G

where;

R = Required Rate of Return

G = Sustainable Growth Rate

P/E Ratio Examples:

If Stock A is trading at $40 and Stock B at $30, Stock A is not necessarily more expensive.

The Price-to-Earning ratio can help us determine, from a valuation perspective, which of the two is cheaper. 

If the sector’s average P/E is 13, Stock A has a P/E = 11 and Stock B has a P/E = 30, stock A is cheaper despite having a higher absolute price than Stock B because you pay less for every $1 of current earnings. However, Stock B has a higher ratio than both its competitor and the sector.

A high P/E ratio could mean that a company’s stock is over-valued, or else that investors are expecting high growth rates in the future.

The P/E ratio is just one of the many valuation measures and financial analysis tools that we used to guide us in our investment decision, and it shouldn’t be the only one.

An every intelligent investor should definitely choose to buy shares of A.

Why the P/E Ratio Is Important:

You probably do not need to calculate each company’s PE ratio, however you can do so only if you’re interested in particular stock, the “P/E ratio formula is price-per-share / earnings-per-share”.

You can see how a low P/E ratio may grab the attention of investors. It could lead an intelligent investor to predict that the company’s stock might be undervalued and therefore a deal worth snapping up.

A lower P/E ratio means that investors are paying less per rupee of company earnings. So while there’s no rule or definite answers for the question “what is a good P/E Ratio?”, by and large, many financial investors consider that lower is better.

On the off chance that you’re looking stocks that appear to be generally comparable and are in a similar business, the one with the lower P/E proportion could be a superior choice in the event that your goal is to buy underestimated stocks.

P/E vs. PEG Ratio

Peter Lynch developed the PEG ratio as an attempt to solve a shortcoming of the P/E ratio by factoring in the projected growth rate of future earnings. That way, if two companies are trading at 15x earnings, and one of them is growing at 3 percent but the other at 9 percent, you can identify the latter as a better bargain with a higher probability of making you a higher return. The formula for PEG is:

PEG Ratio = P/E Ratio / company’s earnings growth rate

A Price to Earnings ratio, even one calculated using a forward earnings estimate, don’t always tell you whether or not the Price-to-Earning is appropriate for the company’s forecasted growth rate.

So, to address this limitation, investors turn to another ratio called the PEG ratio.

Why You Shouldn’t Rely on the P/E Ratio:

It’s a brilliant idea to take the P/E proportion while comparing the stocks for sure. For a certain something, an organization with a high proportion could have a legitimate reason behind that numbers.

Financial investors or specialists may pay even more since they are especially bullish about that organization’s prospects.

An organization with high improvement prospects could have a high Price-to-Earning ratio and still it can be the best choice to buy the stock.

So it’s always worth doing additional research before buying stocks – not just focusing in on the P/E proportion.

The biggest limitation of the P/E ratio: It tells investors next to nothing about the company’s EPS growth prospects.

If the company is growing quickly, you will be comfortable buying it even it had a high Price-to-Earning ratio, knowing that growth in EPS will bring the P/E back down to a lower level.

Conclusion:

The essential thing to recall when considering P/E proportions as one of the parameter of your stock analysis.

It is to consider what premium you are paying for an company earnings today.

Likewise, compare the companies with its same industry to see its relative valuation to decide if the premium is really worth.

Hope you would now have good understanding on what is a Price Earnings Ratio means along with its formula, examples and what is a good Price to Earnings Ratio.

About the author

Avatar

Ganesh B Nayak

Ganesh is an Entrepreneur and a Successful Stock Market investor with 5+ years of experience in Finance Industry. Experienced in all aspects of business formation, operation, finance, and management. Ganesh help finance professionals and Fin-tech startups to build an audience and get more paying clients online.

View all posts
0 0 vote
Article Rating
Subscribe
Notify of
guest
0 Comments
Inline Feedbacks
View all comments