Price-To-Earnings Ratio

What is Price-To-Earnings Ratio ?

Price-To-Earnings ratio is the ratio of a company’s Market price per share to the company’s Earnings per share. It is also known as earnings multiple or PE ratio

It is a benchmark used by investors to understand the current value per share of a company. To illustrate the point, assume the Market price per share of a Company X is $ 10 and Earnings per share is $ 2. Thus, the Price-To-Earnings ratio is $ 10 / $ 2 = 5x. An investor investing in company X is paying 5 times of its Earnings per share to purchase one share of the stock in the market.

It is a common tool used to compare performance of stocks of different companies in the same industry. It is also used to compare current year performance of the company with its previous year’s performance. An increase in the PE ratio in the current year when compared to the previous year indicates that the company is doing well in terms of increasing its market capitalization.

 

How is Price-To-Earnings Ratio calculated ?

The formula for calculating the Price-To-Earnings Ratio is

= Market price per share / Earnings per share

Where Earnings per share is calculated as

Earnings per share = Net income available to common stock holders / Number of shares of common stock outstanding

The market price per share can be obtained from a stock market where the stock is listed.

 

What is a Trailing PE Ratio ?

The trailing PE Ratio is a ratio that is arrived at by using the Earnings per share of the latest 12 – month period.

Thus the Earnings per share for Trailing PE Ratio is calculated by using the net income of the latest 12 – month period available and dividing the same by Number of shares of common stock outstanding.

 

What is a Forward PE Ratio ?

In the calculation of a forward PE ratio, a projected figure or an estimate of Net income available to common stock holders is used to calculate Earnings per share. This figure of estimated or projected earnings per share is then divided by the Number of shares of common stock outstanding to arrive at a Forward PE ratio.

 

What does a high PE ratio signify ?

Companies with a high PE ratio usually have a high market price per share. High PE ratio is a common in start-ups and companies that the investor believes, have a good growth potential. Investing in companies with a high PE ratio is fairly risky as the market price is affected by the volatilities in the stock market. These volatilities are unpredictable and are a function of economic conditions, political conditions etc.  in which the market operates. Thus, for a risk – taking investor, investing in stocks with high PE ratio may turn out to be a gamble.

 

What does a low PE ratio signify ?

Companies with a low PE ratio are characterized by low market price per share. Low PE ratio is mostly seen in companies that are well established and are past their growth spurt.  Stocks of such companies are mostly undervalued. These companies may pay dividends consistently, but cannot provided the investor with capital gains that arise due to increase in market price of stocks.

 

Example :

Arnold & Co.’s shares are currently trading at $ 50.00 per share. The net income of the current year is $ 120,000 with 5,000 shares of common stock outstanding. Calculate the Price-To-Earnings Ratio. ( Round the solution to two decimal places )

 

Solution :

The formula for calculating the Price-To-Earnings Ratio is = Market price per share / Earnings per share

As per the information given in the question we have

Market price per share = 50  ;  Net Income = $ 125,000  ;  Number of shares of common stock outstanding = 5,000  ;

 

We know that Earnings per share = Net Income / Number of shares of common stock outstanding

Thus the Earnings per share = $ 125,000 / 5,000 = $ 25   ;

 

Applying the available information in the formula we have Price-To-Earnings ratio of Arnold & Co. as

= $ 50 / $ 25 = 2

Thus the Firm’s Price-To-Earnings Ratio = 2x = 2 times

 

 

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