Price to earnings ratio (P/E ratio) explained
Common stocks of good companies are not necessarily good investments. Investors must compare the intrinsic value of a stock to its market price before buying it. In relative valuation, the value of an asset can be estimated by looking at how the market prices similar or comparable assets. In other words, the value of an asset is the price that the market based on the asset’s characteristics.
Price to Earnings (P/E) ratio is a market value ratio that relates the firm’s stock price to its earnings and provides management with an indication of what investors think of the firm’s past performance and future prospects. Being the most widely used and well-documented ratio of relative valuation, P/E is often referred to as the ‘multiple’ because it indicates how much investors are willing to pay per dollar of a firm’s reported profits.
P/E is calculated by comparing current share price to earnings per share (EPS). For instance, if a share price is currently at $50 and earnings per share over the last 12 months are $1.85 per share, the P/E ratio for the stock is $50/$1.85=27.02.
P/E can be calculated using earnings per share from the last 12 months, which is commonly referred to as trailing P/E. However, it can also be calculated using forecasted earnings per share expected over the next 12 months, which is commonly referred to as forward P/E. A third approach is to use the earnings per share of the last 6 months and expected earnings per share of the next six months. In reality, there isn’t huge difference between these variations. The only thing that investors need to realize is that in trailing P/E they use actual historical data, while the other two calculations are based on estimates that may be wrong or imprecise.
Generally, a high P/E ratio indicates that a firm has a strong growth prospect. A firm with a P/E higher than the market or industry average indicates that investors expect higher earnings in the near future. However, P/E ratio alone is not enough to convey meaning about a firm’s financial strength. For instance, a $20 stock with a P/E 85 is more expensive than an $80 stock with a P/E 30. To determine whether a P/E is high or low, investors should take into consideration the firm’s growth and the industry. Information about how fast the firm has been growing and if its growth rates are expected to increase in the future is important for investors to understand if projected growth rates justify P/E. If they don’t, then a firm’s stock may be overvalued. In relation to industry, P/E is more useful when compared with the P/E ratios of similar companies within the industry. For instance, it doesn’t make investment sense to compare the P/E ratio of a utility firm that typically has a low P/E ratio to the P/E ratio of a technology firm that typically has a high P/E ratio. Each industry is driven by different dynamics and has different growth prospects.
Overall, investors should avoid basing their investment decisions on P/E ratio alone. Although it reflects the market’s optimism in regards a firm’s growth prospects, buy or sell decisions should not be based on the multiple alone as earnings per share are often subject to accounting manipulation.
I work as a financial and investment advisor but my passion is writing, music and photography. Writing mostly about finance, business and music, being an amateur photographer and a professional dj, I am inspired from life.
Being a strong advocate of simplicity in life, I love my family, my partner and all the people that have stood by me with or without knowing. And I hope that someday, human nature will cease to be greedy and demanding realizing that the more we have the more we want and the more we satisfy our needs the more needs we create. And this is so needless after all.
Article Source:http://www.articlesbase.com/investing-articles/price-to-earnings-ratio-pe-ratio-explained-1259346.html
Related articles by Zemanta
- Ian Cowie: Try to time stock markets at your peril (telegraph.co.uk)
- Dan Solin: Wall Street Packages Luck and Sells It as Skill (huffingtonpost.com)
- Reliance, Bharti, Dish TV (shabbir.in)
- First Listings on Shenzhen Board Priced at High End (nytimes.com)
- Shanda’s Lukewarm IPO Fails To Live Up To The Hype (paidcontent.org)
- Sweetening the dividend deal (money.cnn.com)
- United Utilities’ tax rebate means it still floats our boat (telegraph.co.uk)
- Forget stock price, focus on value (money.cnn.com)
- RIM shares down after disappointing earnings (ctv.ca)
- British Columbia’s multi-family investment market begins to stabilize as prices slowly return to normal levels (newswire.ca)
![Reblog this post [with Zemanta]](http://img.zemanta.com/reblog_e.png?x-id=914af882-2b3c-4a88-b2de-8b770fbc810a)
Share this:
Read also:
- Third Party Car Insurance Can Protect You Against Catastrophic Financial Consequences
- Safe Retirement Accounts
- Candle Charts Confirm Discovery of Powerful New Candlestick Reversal Pattern
- Tapping into the Power of Reverse Marketing for Real Estate Investors
- Sure Shot Intra Day Stock Future Tips
- Online Money Making Opportunities - Investing in Stocks