The standard definition of ‘Price-Earnings Ratio – P/E Ratio’ is the valuation ratio of a company’s current share price compared to its per-share earnings.
The P/E ratio is calculated as: Market Value per Share/Earnings per Share (EPS)
For example, if a stock is currently trading at $50 a share and earnings over the last 12 months were $2.00 per share, the P/E ratio for this stock would be 25.00 ($50/$2.00).
‘Price-Earnings Ratio – P/E Ratio’ Generally speaking, a high P/E suggests that stockholders are anticipating more earning potential in the future when compared to a stock with a lower price to earnings ratio.
Be aware that the P/E ratio isn’t a magic bullet and does not provide you the full picture. It is prudent to compare the P/E ratios of stocks in the same market sector, to the market average or against the stocks own history. Doing your own independent research will help you analyse the stock so you can determine for yourself what its valuation is. It is not an effective investment strategy for investors to use the P/E ratio as a guideline for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E). During your research you will probably discover that as each industry operates at a different growth potential.
The P/E is often referred to as the “multiple”, as it shows how much investors are willing to pay for a stock per dollar of earnings. If a stock was trading at a multiple (P/E) of 20, you can interpret that an investor is willing to pay $20 for $1 of current earnings.
Caution: It is important that investors recognize a potential problem that arises with the P/E measure, and why you should not use P/E to evaluate a stocks viability by this measurement alone. The denominator (earnings) is based on a companies reported earnings and these numbers can be manipulated to report number more favorable to the business and inaccurate for a true valuation, thus making the quality of the P/E only as good as the quality of the underlying earnings number.
As we have been saying from the beginning, you need to do your research before you purchase a stock. You need to be wary of numbers that appear to be too good as they generally are. Though there are examples of stocks in the past that fooled investors into believing they were solid viable businesses by manipulating the numbers. I believe companies who are in multi-national and hold a large market cap in an industry are under too much scrutiny and have too much to lose to be caught fraudulently misrepresenting their financials.