The price to earnings ratio or P/E ratio is computed to find the value of the company that measures the current price of the shares in relative to its per-share earnings. The price to earnings ratio is also known as price multiple ratios or earnings multiple ratios.
The P/E ratio is calculated as Market Value per Share / Earnings per share or Average common stock price / Net income per share.
- Earnings per share are usually derived from the last four quarters. The P/E is calculated by taking the price of the stock at the end and subtracting initial value from it.
- It adjusts stock splits if any. Sometimes, analysts consider the same earnings from the estimates of next four quarters.
Breakdown of Price to Earnings Ratio
The P/E is known as multiple earnings ratio as it shows how much the investors are ready to pay for every rupee of remuneration. The ratio generally says that the investors expect higher earnings in future compared to a lower one as a low P/E implies that company is currently undervalued.
- If the company is under losses, then the P/E will be shown as N/A. Though it is possible to consider a negative P/E, it is not a standard convention in practice.
- The P/E ratio also shows the standardised value of every rupee of earning in the stock market.
- When you find the median of P/E ratio for a number of years, one can find a standardised price earnings ratio which can be used as a benchmark and indicate that the stock is worth buying or not.
Limitations of Price to Earnings Ratio
The significant limitations of P/E ratio arise when we compare the same for different companies. The growth rates and valuations in various sectors of the industry vary due to differing timelines, and operations. Thus, finding P/E ratio for an individual company and comparing it with previous years makes sense but comparison among different companies does not.
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- A high P/E ratio commonly means that the investors can expect the better growth rate in future.
- The average market price-earnings ratio is 20 to 25 times the earnings.
- The price earnings ratio uses estimated earnings to find the forward-looking price-earnings ratio.
- Companies that are facing losses and losing money will not have a price-earnings ratio.
This format or calculation of price earnings is known as projected earning or forward price earnings ratio. Another way to find earnings which is a least used method is taking the sum of two previous quarters and two coming quarters.