P/E Ratio (Price to Earnings Ratio)

Measuring market performance. Explanation of P/E ratio.

P/E Ratio Price to Earnings ratio

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:

It is based on reported earnings, "accounting profits", which are not a good indicator of actual value creation for shareholders.
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 -

P/E Ratio Forum (6)

High PE Ratio Means What? A Good Stock?
What is the meaning if Company A has been trading at a higher PE ratio than company B?
Does it mean we should buy this stock or not?
Can anyone explain? Thanks...

What is the meaning of X in PE Ratio?
Sometimes PE Ratio is given as 12.9x... What does "x" mean?

What is the Beta of a Stock?
Before we're investing in a stock, we not only consider the P/E Ratio, but also the Beta of that particular stock.
Beta is the measurement of how volatile the stock is when compared to the index.
In a nutshell, it can be stated that if a stock's beta is 2, it means that it is two times as volatile as the index.
The earnings and loss will also be twice when compared to the index's.

Conflict of Interest of Management Buy Out
If management is allowed to buy out the companies they work for, would it not be a conflict of interest in that the management can deliberately kill the P/E ratio before their acquisition?