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