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What is P/E Ratio (Price earning ratio) : Formula, Example, Limitations

What is P/E Ratio (Price earning ratio): Formula, Example, Limitations. In the previous articles, we have given Types of Mutual Funds and Debt Equity Ratio Formula, Analysis, How to Calculate, Examples. Today we are discussing what is PE ratio (Price Earings Ratio), Formula, Analysis, and Limitations. It measures how many times the earnings per share (EPS) has been covered by the current market price of an ordinary share. It is computed by dividing the current market price of an ordinary share by earnings per share.

What is P/E Ratio (Price earning ratio) : Formula, Example, Limitations

Formula:

The formula of the price-earnings ratio is given below:

price-earnings-ratio-formula

Example:

The market price of an ordinary share of a company is $80. The earnings per share are $4. Compute price earnings ratio.

Solution:

price-earnings-ratio-formula

=$80 / $4

= 20

The price-earnings ratio of the company is 20. It means the earnings per share of the company is covered 20 times by the market price of its share. In other words, $1 of earnings has a market value of $20.

Points to remember

  • Generally, a high P/E ratio means that investors are anticipating higher growth in the future.
  • The average market P/E ratio is 20-25 times earnings.
  • The P/E ratio can use estimated earnings to get the forward-looking P/E ratio.
  • Companies that are losing money do not have a P/E ratio.
  • If a company wants to acquire companies with a higher P/E ratio than its own, it usually prefers paying in cash or debt rather than in stock. Though in theory the method of payment makes no difference to value, doing it this way offsets or avoids earnings dilution.
  • Conversely, companies with higher P/E ratios than their targets are more tempted to use their stock to pay for acquisitions.
  • Companies with high P/E ratios but volatile earnings may be tempted to find ways to smooth earnings and diversify risk—this is the theory behind building Conglomerates.
  • Conversely, companies with low P/E ratios may be tempted to acquire small high growth businesses in an effort to “rebrand” their portfolio of activities and burnish their image as growth stocks and thus obtain a higher PE rating.
  • Companies try to smooth earnings, for example by “Slush fund accounting” (hiding excess earnings in good years to cover for losses in lean years). Such measures are designed to create the image that the company always slowly but steadily increases profits, with the goal to increase the P/E ratio.
  • Companies with low P/E ratios are usually more open to leveraging their balance sheet. As seen above, this mechanically lowers the P/E ratio, which means the company looks cheaper than it did before leverage and also improves earnings growth rates. Both of these factors help drive up the share price.
  • Strictly speaking, the ratio is measured in years, since the price is measured in dollars and earnings are measured in dollars per year. Therefore, the ratio demonstrates how many years it takes to cover the price if earnings stay the same.

Limitations of ‘Price-Earnings Ratio – P/E Ratio’

Like any other metric designed to inform investors as to whether or not a stock is worth buying, the price-earnings ratio comes with a few important limitations that are important to take into account, as investors may often be led to believe that there is one single metric that will provide complete insight into an investment decision, which is virtually never the case.

a) One primary limitation of using P/E ratios emerges when comparing P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due both to the differing ways companies earn money and to the differing timelines during which companies earn that money. As such, one should only use P/E as a comparative tool when considering companies within the same sector, as this kind of comparison is the only kind that will yield productive insight.

b) An individual company’s P/E ratio is much more meaningful when taken alongside P/E ratios of other companies within the same sector. For example, an energy company may have a high P/E ratio, but this may reflect a trend within the sector rather than one merely within the individual company.

c) Moreover, because a company’s debt can affect both the prices of shares and the company’s earnings, leverage can skew P/E ratios as well. For example, suppose there are two similar companies that differ primarily in the amount of debt they take on. The one with more debt will likely have a lower P/E value than the one with less debt.

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