What is the price-earnings ratio (P/E)?
The price-earnings ratio (P/E) is a share valuation metric commonly quoted in the financial media. The formula to calculate the P/E ratio is the company's share price divided by its earnings (or profit) per share.
For example, if a company's share price is $10 and its earnings per share last year was $1, its P/E ratio is ($10/$1) 10 times (sometimes shown as 10x). Given that the formula uses last financial year's earnings per share, this is sometimes called a trailing P/E ratio.
What is a 'forward' P/E ratio?
Sometimes, the P/E ratio is calculated using analyst forecasts for the next financial year's earnings per share.
For example, if a company's share price today is $10 and its forecast earnings per share is $1.50, the P/E ratio is ($10/$1.50) 6.6x.
Where can I find a company's earnings per share (EPS)?
Investors can find a company's earnings per share in its half-yearly or annual financial reports, at the bottom of the 'Income Statement'.
What does the P/E tell us?
The P/E ratio gives investors an indication of how expensive a company's shares are relative to its yearly profits. A lower P/E is often perceived as being 'cheaper'.
However, it's important to remember that share prices often take into consideration the future expectations of the company, whereas the P/E ratio is taken at a point in time, kind of like a photograph.
A company's P/E ratio can also be compared to its peers. Once again, a lower P/E is seen as a positive. However, two public companies are rarely the same.
Finally, a very low price-earnings ratio can be a cause for concern. This may suggest the company is higher risk or expected to face financial difficulty.
Test Your Knowledge
China Doll Corp has a P/E of 2x. Is China Doll Corp a buy?
A price-earnings ratio is only one valuation measure. What's more, it is only a point-in-time metric, like a photograph -- and there can be a lot more going on behind the scenes!
UK Company Ltd has a share price of $30 and earnings per share of $3. What's its P/E ratio?
The P/E ratio equals share price divided by earnings per share. Therefore, UK Company Ltd's P/E is $30/$3 = 10x.
Down Under Ltd has a share price of $5. Last year, it made $1 in earnings per share. An analyst forecasts it to make $0.50 next year. What's the forward P/E ratio?
The forward P/E ratio is calculated using forecasts. In this case, we have $5 (share price) divided by $0.5 (earnings per share) which equals 10x.
France Company Ltd has a P/E ratio of 20x and is a direct competitor of Italy Company Ltd, which has a P/E ratio of 10x. Based only on the P/E ratio, which company's shares are cheaper?
Using the P/E ratio, lower is typically better. Italy Company Ltd has the lower P/E ratio. However, it's important to understand the risks of owning any company's shares and consider using other valuation techniques.
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