Price to Earnings

SeekingAlpha  Aug 25  Comment 
By Nick Gogerty: Piketty, thinking about value, shows why the inequality R>G must be. In his new book Capital in the 21st Century, Thomas Piketty discovers that Returns on Capital (R) are greater than the gains of economic growth (G) leading which...
SeekingAlpha  Aug 18  Comment 
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 Its pleasing simplicity and ease of application make the P/E...
SeekingAlpha  Aug 6  Comment 
Sometimes we feel that DQYDJ gets an unfair reputation as a solely-individual investing "beat the market" type blog. While our most prolific writer (…me), does maintain an actively traded portfolio, we just did the math - it's only 37.4% of our...
SeekingAlpha  Jul 29  Comment 
By The Dividend Guy: The market is too high, it has to go down… I bet you have heard this more than a few times recently. Some investment gurus came out of their tombs and are back with their favorite REM song: "This is the End of the World as...
SeekingAlpha  Jun 4  Comment 
By Sure Dividend: The Shiller PE ratio is approaching 26... near 2007 highs, and just below the Shiller PE ratio of 30 on Black Tuesday (start of the Great Depression). The Shiller PE Ratio Explained The Shiller PE ratio is the current price...
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.


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.

See Also

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