Meaning of price earnings ratio
- Price multiple or P/E Ratio is the ratio for valuing a company at its current share prices relative to the EPS or the Per Share Earnings.
- P/E Ratio= Market value per share/ Earnings per share
A high P/E ratio implies that the company's shares are overvalued or that there will be high growth rates for the company in the near future.
Types of P/E ratio
Forward P/E – indicates the company’s best educated guess about what one can expect in the future. One inherent problem is that companies could underestimate, play the underdog, and then beat the estimate in the next quarter. The converse could also occur.
- Trailing P/E – is when the numbers signify the performance of the company for the past 12 months. It is a more popular metric as the figures are objective, however, it suffers from lack of accurate prediction about the future.
- Please note: The investors are to expect a decrease in earnings, if the forward P/E is higher than the current P/E ratio and vice versa.
- Absolute P/E – it represents the P/E of the current period.
- Relative P/E – compares the absolute P/E to a benchmark or a range of P/E for a stipulated time period. It can be used to see how close the current P/E is to the historic high or low of the company.
Uses of P/E ratio
- To determine the relative value of the company’s shares with respect to other companies.
- To compare a company against its own historical record.
- To compare the aggregate markets against one another over a period of time. The stocks can even be evaluated against a benchmark like the S&P 500 index.
- Taking the median of P/E ratios over the years can help one formulate a standardized ratio that can be used as a benchmark while making a decision as to whether or not to purchase the stocks.
Limitations of the P/E ratio
P/E ratio cannot be used for companies that have no earnings or those which are losing money as there is no value that can be placed in the denominator. In such cases P/E will be expressed as N/A.
Difference Between P/E Ratio and Earnings Yield
- Earnings Yield is the inverse of P/E ratio i.e. it is the Earnings per share/ Market value per share. It is expressed in percentage terms.
- The Earnings Yield proves to be a useful metric when the company has zero or negative earnings.
