The price to earnings ratio or the PE, is simply the ratio of a company’s share price divided by the that particular company’s earnings per share, earnings per share being the company’s net profit after tax divided by the number of issued shares of that company. For example, if company A has earned a net profit after tax of $1000 and it has 100 issued shares, then the company’s earnings per share is $1000 divided by 100 issued shares which is $10. If company A’s shares are trading at $100 per share on the stock exchange than company A’s price to earnings ratio is $100 divided by $10 which is 10. Now, what the price to earning ratio means is that it will take 10 years for a shareholder of company A’s shares to earn $100 being the current share price if the shareholder purchased the shares at $100 per share with the current earnings per share of $10.
The price to earnings ratio is used by investors who invest in companies listed on stock exchanges around the world. The ratio can be used determine whether a company’s share is too high or overvalued and also to determine whether a company’s earnings is on a decreasing trend. The PE ratio can also be used to compare PE ratios of other companies in order to determine which shares will payback in the least time. Usually, the lower the PE ratio, the better the investment is because investors will earn the money they spend on the shares in the least time. For example, if the PE is 20, this would mean an investor will earn his or her money spent on buying the shares in 20 years time. On the other hand, if the PE is 5, this would mean an investor will earn his or her money spent on buying the shares in only 5 years which is important as the money recouped or earned from the shares can be used to invest further.
Depending solely on the PE ratio is not a good practice. It should only be used with other ratios when making decisions. There are several reasons why using the PE ratio is not a good practice but one very important and often overlooked reason is that share prices change according to each investor’s outlook for the future which can be based on personal reasons or reasons which are not acceptable to the whole market. For example, a shareholder is desperate need of cash can sell their $100 worth shares at only $50 per share. This will distort the PE ratio because it will significantly decrease, say, for example, if the current price is $100 and earnings per share is $10, than the PE ratio will be 10 but if a desperate seller sells his or her shares now at $50, the PE ratio decrease to 5 which may seem attractive to investors however, as the decision to sell was based on desperation and not on earnings per share or other ratios, investors may suffer loses. A vice versa situation can be taken where say for example, a huge corporate firm buys at higher prices than at current market prices to increase its shareholding in a particular company. This can make a particular invest in a share seem unattractive as the higher prices will increase the PE ratio, however, investors must realize that the new PE is only an one-off event, again based on reasons other than the company’s performance itself.
Thus, using the PE ratio is good a way to determine how long it will take to earn your money back, spent on buying shares however, it should not be used solely to make investment decisions due to the volatile nature of the stock markets.