Price-Earnings Ratio (P/E Ratio)

A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:

For example, if a company is currently trading at $43 a share and earnings over the last 12
months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken
from the estimates of earnings expected in the next four quarters (projected or forward
P/E). A third variation uses the sum of the last two actual quarters and the estimates of
the next two quarters.

Also sometimes known as "price multiple" or "earnings multiple".

In general, a high P/E suggests that investors are expecting higher earnings growth in the
future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us
the whole story by itself. It's usually more useful to compare the P/E ratios of
one company to other companies in the same industry, to the market in general or against
the company's own historical P/E. It would not be useful for investors using the P/E ratio
as a basis for their investment to compare the P/E of a technology company (high P/E) to
a utility company (low P/E) as each industry has much different growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors
are willing to pay per dollar of earnings. If a company were currently trading at a
multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of
current earnings.

It is important that investors note an important problem that arises with the P/E measure,
and to avoid basing a decision on this measure alone. The denominator (earnings) is based
on an accounting measure of earnings that is susceptible to forms of manipulation,
making the quality of the P/E only as good as the quality of the underlying earnings
number.

If a company has a P/E higher than the market or industry average, this means that the
market is expecting big things over the next few months or years. A company with a high
P/E ratio will eventually have to live up to the high rating by substantially increasing its
earnings, or the stock price will need to drop.

A good example is Microsoft. Several years ago, when it was growing by leaps and
bounds, and its P/E ratio was over 100. Today, Microsoft is one of the largest companies
in the world, so its revenues and earnings can't maintain the same growth as before. As a
result, its P/E had dropped to 43 by June 2002. This reduction in the P/E ratio is a
common occurrence as high-growth startups solidify their reputations and turn into blue
chips.

The P/E of a company tells us how much investors are willing to pay, based on the
earnings of the company. For this reason, the P/E ratio is also known as the P/E multiple
of the stock. For example, a P/E ratio of 25 suggests that investors are willing to pay Rs 25
for every Re 1 of earnings that the company generates.

Investors look at the P/E ratio as future market expectations of a company’s growth
prospects in terms of profitability. If the P/E of a company is on the higher side when
compared to its industry averages, it means the market is expecting some positive events
from the company as far as earnings are concerned.

Take, for example, the retail sector in India. It’s a fairly new industry and many
Companies are showing accumulated losses in their balance-sheets. Yet, the industry has a
P/E ratio of 40. This shows that investors are confident of the prospects for this industry.

P/Es should ideally be compared with Companies belonging to the same industry, as
broad factors affecting these Companies do not change. For example, comparing a
software company with a commodity business will not make sense, as industry dynamics
are different.
The P/E ratio (price-to-earnings ratio) of a stock (also called its "earnings multiple", or
simply "multiple", "P/E", or "PE") is a measure of the price paid for a share relative to the
annual income or profit earned by the firm per share.[2] A higher P/E ratio means that
investors are paying more for each unit of income. It is a valuation ratio included in other
financial ratios. The reciprocal of the P/E ratio is known as the earnings yield.[3]

The price per share (numerator) is the market price of a single share of the stock. The
earnings per share (denominator) is the net income of the company for the most recent 12
month period, divided by number of shares outstanding. The earnings per share (EPS)
used can also be the "diluted EPS" or the "comprehensive EPS". The P/E ratio can also be
calculated by dividing the company's market capitalization by its total annual earnings.

For example, if stock A is trading at $24 and the earnings per share for the most recent 12
month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the
purchaser of stock A is paying $8 for every dollar of earnings. Companies with losses
(negative earnings) or no profit have an undefined P/E ratio (usually shown as Not
applicable or "N/A"); sometimes, however, a negative P/E ratio may be shown.

By comparing price and earnings per share for a company, one can analyze the market's
stock valuation of a company and its shares relative to the income the company is actually
generating. 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, all things being equal (especially the earnings growth
rate), it is a less attractive investment. Companies are rarely equal, however, and
comparisons between industries, companies, and time periods may be misleading.