The price earnings ratio is a means of measuring the value of a share against its earnings. It consolidates a lot of financial data from a company’s performance and distills it into a single figure easy to interpret. Investors use this metric to assess if a stock is being sold or bought at a discount or a premium price in light of its value. This article will explore the what the ratio means, how to calculate it, what it implies and what its strengths and weaknesses are.
The Concept of Price Earnings Ratio
The price earnings ratio is calculated by dividing a company’s stock price by its earnings. A low ratio indicates a lack of confidence in the future growth and performance of a company. Investors do not foresee any improvement in performance and will only pay less per share. The ratio offers a reflection of what the market thinks about a company.
It is also a way to benchmark the value of one dollar of earnings in an industry. This is achieved by taking the ratio in one industry over several years and getting the median. The result can be a standard against which to measure any stock purchases in that industry.
Formula and Uses
The formula for obtaining the price earnings ratio is equal to a company’s market value per share divided by its earnings per share. It is an indicator of the amount an investor is willing to pay based on the stock’s earnings. For this reason, it nicknamed the multiple. As a reflection of the anticipated share price based on its earnings, the ratio rises in tandem with a company’s rise in share earnings. Conversely, when the earnings per share fall so does the ratio. A company with a high price earnings ratio usually indicates an expected growth in future performance. Because investors predict an increase in earnings per share, they are willing to pay more.
There are two types of price earnings ratio:
- Trailing ratio – derived by using the earnings per share from the last four quarters.
- Forward ratio – arrived at by using the projected earnings per share from the upcoming four consecutive financial quarters.
When a company has no earnings or if it is making a loss, the ratio is denoted as “N/A.” A negative ratio is rarely ever used to express such situations.
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The Strengths and Limitations of the Price Earnings Ratio
As with any other accounting metric, there are advantages and disadvantages to using it. It is an easy-to-use measure that is quickly discernible even to those who aren’t as skilled in finance. The ratio offers more insight into how much a company’s share is worth as compared to using the share price alone. It is also prone to management manipulation due to it taking earnings per share into account. During inflation, the price earnings ratio isn’t as clear an indicator. The ratio only adds value when comparing companies in the same sector.
Advantages of Using the Price Earnings Ration
1. The Price Earnings Ratio Is Easy to Understand and Apply
For many who are not adept at financials, this is an advantage. Its simplicity makes it easy to use in making quick decisions for investors. It enables an investor to compare the current and past preface of a company’s stocks. This comparison leads to a clearer picture of whether a company has been growing or failing.
2. It Provides Input into What the Projected Future Performance Might Be
For example, a company can have shares that keep earning more profit over a period, yet its ratio remains near constant. When the comparison in performance over time is analyzed, it becomes apparent that the growth of the company doesn’t match its share price growth. As a result, an investor can discern the undervaluation of such a company and make a purchase.
3. It Is an Efficient Means of Gaining Insight into What a Company’s Share Is Worth
This is more beneficial than if an investor only uses the share price. For example, company A has a share price of $150 and a ratio of 10. Company B which operates in the same sector has a share price of $50 and a similar ratio of 10. Though the shares belonging to company A have a higher price, they are in effect cheaper as compared to company B’s. That degree of insight is an intrinsic feature of the ratio.
Disadvantages of Using the Price Earnings Ratio
1. The Ratio Is Susceptible to Manipulation by Management
This is because although the market price per share information is determined externally, the earnings per share are not. The company provides the market with how much each share generates. There is, therefore, an opportunity for the company’s leadership to manipulate the earnings per share they report, affecting the ratio.
2. The Ratio Is Only Effective When Comparing Companies in the Same Sector
This limits its scope of use in precisely assessing a wider array of firms. For example, company A might have a higher ratio than company B which is from a different sector. The high ratio could be due to a trend in the industry company A is in, rather than factors within its operation. As a result, the high ratio would be less of an edge considering the similar trend in the sector it is in.
3. The Ratio Doesn’t Take Debt into Account
The debt affects a company’s earnings and share price. When a company is highly leveraged, it will have a lower ratio and may not be as favored. But if the company operates with a good business model that leads to growth, earnings will increase despite the debt. Inflation also skews the accuracy of the ratio. The market tends to perform poorly resulting in a lower market value per share. The earnings per share will outweigh the share price in such cases leading to a low P/E ratio. Such a situation doesn’t give a clear depiction of the business.
The price earnings ratio is a metric that is easy to understand and apply. It provides more accurate insight into what a company’s stock is truly worth compared to using the share price alone. It does have some downsides and as such should not be the sole determinant in making share purchase decisions. If you take all risks into account, this ratio is an efficient means of measurement. What are your thoughts on this ratio? Share them in the comments below.