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Price-Earnings Ratio

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Example:

Find the trailing, leading and justified P/E values for a share of Ms. T, Ltd. when:

  • Current market price = $20
  • EPS (current period) = $2.
  • EPS (next period) = $2.5
  • Expected payout ratio = 40%
  • Required rate of return = 12%
  • Growth rate = 6%
  • Trailing P/E = current share price ÷ current year EPS = $20 ÷ $2 = $10
  • Leading P/E = current share price ÷ next year’s EPS = $20 ÷ $2.5 = 8
  • Justified P/E = payout ratio ÷ (required rate of return − growth rate) = 40% ÷ (12% − 6%) = 40% ÷ 6% = 6.7
Price-Earnings Ratio Definition

The price-earnings ratio compares the price of an equity to its earnings. The ratio is calculated as a company's share price divided by its earnings per share. The P/E compares what an investor has to pay for a share to its return in investment (earnings). Analysts and investors use the ratio to decide whether the share price of a company is fairly valued, undervalued or overvalued. Investors can analyze the market's stock valuation of a company and its shares relative to its income.

  • P/E ratios calculated with expected (projected) data are called leading P/E values. They are considered a more meaningful estimate of the company's justified P/E ratio
  • The current share price is obtained from secondary markets like the NYSE and NASDAQ. The EPS is calculated as: (net income – value of preferred dividends) ÷ weighted average number of shares outstanding.

Analysis

Stocks with higher or more certain forecast earnings growth will usually have higher P/E values. This is a positive indicator for growth-oriented investors. Stocks expected to have lower or riskier earnings growth will usually have a lower P/E value.

Investors can use the P/E ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, it is viewed as a less attractive investment. However, P/E comparisons of stocks in different industries or measured for different time periods might be misleading. In general, P/E ratios are most useful to compare the earnings of peer companies in a similar business sector or industry.

P/E Ratio = Current share price ÷ earnings per share