Price to Earnings Ratio (P/E)

by Investing School on November 17, 2008

The price to earnings ratio (denoted P/E) measures the relationship between the share price to its earnings per share. It is considered one of the most important metric of a company because comparing two similar companies’ P/E shows us which is a better value. Sometimes, people will refer to this ratio as the price to earnings multiple, or simply the multiple of a company.

What Price-Earnings Ratio Represents
The P/E ratio lets investors know what the price of a particular stock is related to the earnings it makes. If a company makes $5 and has a share price of $50, then the P/E is simply 10 (50 divided by 5). With this information, an investor can clearly see that the general public is currently willing to pay $10 for every $1 that the company makes. This also means that the lower this number, the better value the investment potentially is.

What the Ratio is Telling Us
Investors love growth. So a high P/E usually represents the general public anticipating high growth in the months ahead. This could be based on the company’s track record, anticipation of a new product launch, or macroeconomics such as a good economy.

In some ways, this ratio also tells us the confidence level in the stock. When investors are willing to pay a higher multiple for a stock versus another, it generally means that they are more confident that the company’s share price will rise quicker the rest.

A Simple Example
Company A and B having a stock price of $20 and $30 respectively says nothing about the relative value of the enterprises. However, if they both earn $1 per share, then comparing their P/E ratio of 20 and 30 tells us that investors are currently willing to pay $20 for each dollar that company A earns and $30 for each dollar company B makes. With this information, we can see that company A is a relatively better value than company B if all else is equal.

What to Watch Out For
Investors need to take caution when comparing P/E ratios of two companies. If we look at different industries, we will see vast differences in P/E ratios. For instance, technology stocks’ having a P/E of 30 is not uncommon but an oil service company may have a P/E of 10. While the oil service company may look like a better value, it does not mean that every oil service company is a better investment than a technology company. Therefore, P/E ratios should be used to compare companies in the same sector.

Another point to remember is that there are usually valid reasons why the general public is willing to pay a higher multiple for a given company. Usually, a company with a good track record will command a higher multiple because it is less likely to disappoint the public (ex. earnings miss, slashing dividend, surprising outlook cut etc). So while it is important to compare the P/E ratio of two companies as one of the metrics to determine value of potential investments, remember to make your judgments according to the big picture.

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