The price / earnings ratio (or P / E ratio) is the valuation ratio of a company that measures the current price of its shares in relation to its earnings per share. The price-earnings ratio can also be known as a “price multiple” or a “multiple of earnings.”
The P / E ratio can be calculated as: market value per share / earnings per share.
Breakdown of the price-earnings ratio
In essence, the price-earnings ratio shows you the dollar amount that you can expect to invest in a company to receive one dollar of that company’s earnings. This is why the price-earnings ratio is sometimes known as the multiple of price, as it aids in deciding how much investors are willing to pay for each dollar of earnings. If a company is currently trading at a multiple (P / E) of 10, the interpretation is that an investor is willing to pay $ 10 for $ 1 of current earnings.
To calculate the price-earnings ratio, you must first know the earnings per share, or EPS. EPS is most often derived from financial information for the last four quarters. This form of the price / earnings ratio is called the end-of-period P / E, which can be calculated by subtracting the value of a company’s stock at the beginning of the 12-month period from its value at the end of the period. The value should be adjusted for share splits, if applicable.
On occasion, prices and earnings can also be taken from analyst estimates of expected earnings for the next four quarters. This form of price gain is called a projected P / E or future P / E. A third variation, less common than this, is the one that uses the sum of the last two real quarters and the estimates of the next two quarters. The choice of these alternatives depends on the criteria of the analysts in relation to the current characteristics of the company.
Insights for investors from the price-earnings ratio
In general, achieving a high P / E in a company suggests that investors expect higher earnings growth in the future compared to companies with a lower P / E in the same category. On the other hand, a low P / E can indicate both that a company may be currently undervalued and also indicate that the company is doing exceptionally well relative to its past trends. When a company has no profit or is recording losses, in both cases the price-earnings ratio will be shown as “N / A”. It is not common to express a negative P / E, but to indicate that the result does not apply.
Obtain market standards
This price-earnings value can be used to standardize the value of a dollar of profit in the stock market. This would mean taking an average of the price-earnings ratios over a period of several years, and thereby formulating something similar to a standardized price-earnings ratio. Such a standard could be considered as a benchmark that indicates whether a stock is worth buying or not.
Limitations of the price-earnings ratio
It is important to recognize that no financial metric can provide us with a complete understanding of a company in relation to investment decisions. Like other metrics, the price-earnings ratio also has limitations that must be taken into account.
One of the main limitations of the use of P / E ratios is when comparing the P / E ratios of different companies. Business valuations and growth rates can vary greatly from industry to industry due to both the different ways that companies make money and the different timeframes over which companies make that money. As such, the P / E should only be used as a comparative tool when considering companies in the same sector, since this type of comparison is the only one that allows an objective point of view to be obtained.
On the other hand, comparisons may be necessary and useful when they are made between companies in the same sector. The validity of the price-benefit ratio as a good indicator increases when it can be compared with others, since in this way it can be seen if a certain result corresponds to a common market situation.
Additionally, since a company’s debt can affect both share prices and company earnings, leverage can skew profitability ratios as well. If we think about the comparison of two companies that have different amounts of debt, the company that has a larger debt will have a lower price-earnings ratio at that time, compared to the second. However, the former could have better growth and offer better returns in the long run, because it has taken risks correctly.
Another important limitation of the price-earnings ratios is the one found within the formula for calculating the P / E itself. Accurate and unbiased presentations of price-to-earnings ratios are based on accurate data on the market value of stocks and accurate estimates of earnings per share. While the market determines the value of stocks, and as such information is available from a wide variety of reliable sources, this is less true of earnings, which are often reported by the companies themselves and therefore, they are more easily manipulated. In other words, since earnings are an important input in calculating the PER, adjusting them may also affect your result. This needs to be taken into account specially when investing in companies within sectors or global regions that have more “loose” governing institutions in the financial markets.
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