Price/Earning ratio

DEFINITION of Price/Earning ratio

The price/earning ratio is one of the most tools and an important metric for stock selection. It is a useful metric for evaluating the relative attractiveness of a company’s stock price in comparison to the current earnings of a firm.

WHAT IT IS IN ESSENCE

Benjamin Graham made it. He was dubbed the “Father of Value Investing” as well as Warren Buffett’s mentor. Graham promoted the virtues of this financial ratio. He claimed that this as one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis often offering some modifications and additional clarification.

So it had added utility when viewed in light of a company’s overall growth rate and underlying earning power.

But remember,  you can’t always rely on price-to-earnings ratios as the be-all-end-all yardstick in determining whether a company’s stock is expensive.

By dividing a company’s current share price by its earnings per share, traders are able to assess the level at which its shares are trading compared to the profit it’s making.

If a company has a high P/E ratio, then anyone buying its shares is usually anticipating that earnings will increase in the future to justify its lofty valuation.

On the other hand, it may just indicate that the company is currently overvalued.

Different industries will have different average P/E ratios. So the definition of a high P/E various between assets.

Growth companies will tend to trade with higher P/E ratios than established blue chip stocks.

HOW TO USE

You can calculate it as a company’s share price-dividend by its earnings per share (EPS).  It shows the sum of money you are ready to pay for each amount worth of the earnings of the company.

P/E ratio = Share price / Earnings per share

P/E ratio also refers to price to earnings, PE ratio or price-earnings multiple.

Simply put, the p/e ratio is the price an investor is paying for $1 of a company’s earnings or profit.

In other words, say a company is reporting earnings per share of $3. And its stock is selling for $30 per share. Hence the p/e ratio is 10 meaning, $30 per share divided by $3 earnings per share = 10 p/e.

This is stock price divided by annual earnings per share.