Price Earning (PE) ratio

Understand

The price earning (PE) ratio also known as P/E ratio, price to earning ratio is a business valuation ratio which measures current share price of a company with respect to its recent earnings per share to indicate how much amount of dollar an investor willing to pay to get one dollar from company’s earnings. For example, the current share price of the company is $20 and it’s earning per share is $2. By using P/E ratio, we can measure that to get $1 from earnings, we will need to pay $10 for it.

It is often used to carry the quick analysis of different securities or shares to see which one require less dollar amount to get one dollar from their earnings. Companies with the higher price to earning ratio are often considered that they have a higher potential for future earnings and will pay more dividend whereas lower P/E ratio may depict that company is being undervalued or the company is doing well relative to its past trends.

Formula

The price earning ratio = Market price per share / Earning per share

Example

Suppose that you have $200 to invest and evaluating P/E ratio of three companies within the same industry. The company A has P/E ratio of $10, company B $14 and company C $19. Although company A requiring less, $10 to pay in order to get $1 from earning but you should consider higher P/E ratio company C because it may generate more dividend than others due to its ability to generate more profit with help of sufficient funds available.

Limitations of Price Earning (PE) ratio

  • This ratio is only useful if two companies are being compared within the same industry.
  • The accuracy of the ratio depends on its inputs of market price and earning, for example, a company may manipulate its earnings.
  • It does not provide enough insight into how the company is earning money.
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