Price to Earnings

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By David Trainer: The Price to Earnings (P/E) ratio is in the Danger Zone this week. Check out this week's Danger Zone Interview with Chuck Jaffe of Money Life and Marketwatch.com. Its pleasing simplicity and ease of application make the P/E...
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The Economic Times  Jan 20  Comment 
It is important for small investors to understand basics of such ratios to help them analyse stocks more effectively. Find out EV/EBITDA ratio preferred by some analysts over PE ratio.
Sydney Morning Herald  Oct 3  Comment 
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Market Intelligence Center  Sep 23  Comment 
One of the most popular criteria investors use when screening for companies is a stock’s P/E ratios. When I use screeners to narrow down the stock universe, I tend to use a maximum P/E ratio of 30, but even then, I prefer to go with stocks...




 

P/E equals current share price divided by earnings per share

The P/E (or "Price to Earnings ratio") is the most common measure of the cost of a stock. The P/E ratio can be calculated one of two ways, either as a stock's market capitalization (total shares times cost per share) divided by its after-tax earnings, or as the current share price divided by earnings per share.

For example, the P/E ratio of company A with a share price of $50 and earnings per share of $5 is 10.

The higher the P/E ratio, the more the market is willing to pay for each dollar of annual earnings. In general, a low P/E is considered a sign that a stock may be undervalued, or that investors expect poor future earnings. By contrast, a high P/E is thought to indicate an over-valued stock, or one that is expected to post significant earnings increases.

It should be noted that there is no mathematical basis for what a company's P/E should be. Rather, a high or low P/E is defined only in relative terms. Historically, P/E ratios for US listed companies have averaged between 14 and 16, though functionally, stocks with P/E below about 12 are considered "low" while P/Es above 40 or 50 are considered "high", in absolute terms. A P/E's significance (i.e. "high" or "low") on more general terms is dictated by a company's P/E in relation to its industry and competitors. In other words, the industry a company is in often has as much to do with its P/E ratio as the company's performance, and therefore the metric may be useless unless taken in context. Thus, because of the major discrepancies in earnings results across sectors, P/E ratios are most useful when comparing companies in the same industry.

Capital Structure Bias

One weakness of P/E ratios is that they are impacted by a company's choice of capital structure. Companies that have chosen to raise money via debt will often have lower P/Es (and therefore look cheaper) than companies that raise money by issuing shares, even though the two companies might have equivalent enterprise values. For example, if a company with debt were to raise money by issuing shares of stock, and then used the money to pay off the debt, this company's P/E ratio would shoot up because of the increased number of shares - although nothing about the fundamental value of the business has changed.

This makes it difficult to use P/E ratios to compare different companies with different amounts of leverage. As a result, ratios of EV / EBITDA, which are unaffected by capital structure, are a more effective way of comparing the "price" of two different companies.


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