Price-to-earnings (P/E) ratio measures a company’s share price in relation to its earnings per share.
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What is the Price-to-Earnings Ratio?
Price-to-earnings ratio determines how much investors are willing to pay per company’s earnings. Investors can assess the value of a stock on the stock market by its Price-to-ernings ratio. Investors compare the present value of a company to its past performance against other companies in the same industry to determine what company stocks to invest in.
Understanding P/E ratio
The price-to-earnings ratio determines whether investors overrate or underappreciate a stock. However, determining this requires comparing a company’s PE ratio to the PE ratios of other companies in the same industry. People mainly calculate price-to-earnings ratios in two forms. Calculating based on future estimations, the forward P/E ratio compares current earnings to potential future earnings. A more precise approach is the trailing P/E which involves dividing the current share price by the earnings per share of the last 12 months.
P/E Ratio Formula
The Price-to-earnings ratio of a stock is calculated by dividing the current share price of a stock by its earnings per share
P/E ratio = Current share price/Earnings per share
For example, company ABC has a current price per share of 50.00NGN and its earnings per share for the past 12 months is 5.00NGN. Applying the P/E ratio:
P/E ratio = 50/5 =10.00NGN
Therefore, investors are willing to pay 10.00NGN for every naira of company ABC’s profits.
What does the Price-to-Earnings Imply?
Companies with high P/E ratios are referred to as growth stocks. Investors often have high future earnings expectations of such stocks and are willing to pay any amount. However, investing in high P/E ratio stocks can be risky, because stocks can be overvalued in a market. Stocks with low P/E ratios are referred to as value stocks. Investors see these stocks as undervalued or they have slow growth prospects. Still, they invest to buy at a low price and sell at a higher rate when stock value increases. Some established companies with steady dividend rates have low Price-to-earnings ratios.
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What is a good PE ratio for stocks?
A good price-to-earnings ratio is subjective and differs across sectors. Investors may see a low P/E ratio as a potential gold mine, especially if the company has solid growth prospects. However, a low PE ratio could signify underlying financial issues. A high P/E ratio could stir up unattainable expectations in investors, which may lead to massive capital loss if the stocks are overvalued.
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