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What is the Price to Earnings (P/E) Ratio?

Date: Sep 30, 2022 | Time: 06:23:00 PM | Author: Editor News

To have a better understating of the company's value, the Price to Earnings (P/E) ratio can be relied upon. Such a formula is used for the determination of stock valuation and is used by analysts and investors. The widely used metric could disclose how the value of the stock matches up to its counterparts in the industry or a benchmark such as the S&P 500 index. Based on past or future earnings, the P/E reveals what a market is like to give for a stock. For the calculation of this ratio, investors and analysts may think of considering the earnings for different periods. Nevertheless, the earnings of a company for one year or from the last 12 months are often deemed as the most popular variable.

Before delving deep into the subject, let's try to know what price-to-earnings (P/E) ratio is all about.

Definition of P/E ratio

The P/E ratio is the ratio of a stock's share price to its earnings for each share (EPS). At times, they are also known as earnings multiple or price multiple. When the price of the stock is excessive in terms of earnings and over-priced, the P/E ratio will be indicated as high. On the other hand, whilst the current stock price is less connected to earnings, then it is considered a low P/E ratio.

Companies such as technology companies have higher P/E since they grow faster. In such conditions, due to the prediction of growth of these companies, investors would be willing to invest in better share prices currently.

How to calculate P/E?

The current P/E can be calculated by dividing market value price per share by EPS (Earnings by share), which is the total earnings of the last year divided by the weighted average share outstanding. EPS is used to assess the financial strength of a company. It is the portion of the net income of a company, which would be generated per share when all profits were distributed to shareholders.

Types of P/E ratio

· Forward P/E ratio: Also known as estimated P/E, forward P/E is associated with the future earnings of a company. It could be determined by dividing the amount of a company's single unit of stock by the company's expected earnings of a company depending on its future earnings projection. This kind of P/E is applied by investors to estimate how a company is anticipated to perform in the future and also the forecasted growth rate.

· Trailing P/E ratio: It could be deemed as the most frequently used indicator by the investors that determines the past profits of the company. This would comprise the past details over some time. With trailing P/E, more specific and independent performance of the company can be analysed.

What could be considered a 'good P/E ratio'?

At various valuation, (PE) levels various sectors are traded. Since stocks with better profit growth potential have higher P/E ratios, we cannot employ a single P/E level to evaluate if the price of the stock is favourable or not. To determine whether the current PE is on the lower or upper edge end of the range, you should examine the past PEs of the stock. It would be a solid investment opportunity and hence a 'good P/E ratio' when the stock is trading somewhere around the bottom of the range.

How is the Absolute P/E Ratio different from the Relative P/E Ratio?

Again these two types of P/E ratios are used to assess a company's performance. The process of dividing the current stock price by either future or past earnings of the company is termed the absolute P/E ratio and it is considered the traditional P/E ratio. Whereas, the relative P/E ratio is calculated by the absolute ratio of a company along with the benchmark P/E ratio or the previous P/E of corresponding companies.

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