Price-to-Earnings Ratio

Investment Dictionary -> Price-to-Earnings Ratio

A price-to-earnings ratio (P/E) is financial ratio that is used for the purposes of valuation. It compares the share price with the profit or the net income per year, earned by the firm (also per share).

Generally, a higher P/E means that the investors expect better future growth of their earnings. The P/E, however, is not a universal ratio and does not reveal the whole picture. It is better to compare the P/E ratios of companies within one industry, compare them to the whole market, or make a comparison between the historical companies` price-to-earnings ratios. It would be useless for anyone to compare the P/E of a tech company with the P/E of a furniture company. The reason is that the growth prospects in the different industries also differ.

Another way the P/E is referred to as in the financial world is “multiple”. The reason is that it indicates the willingness of the investors to pay per dollar of the earnings. It is generally accepted that an investor will find it acceptable to pay $30 for $1 of current earnings if the company is presently trading at a multiple (P/E) of 30.

The investors should take care not to base their decisions on this measurement alone as it is not universal. Decisions should be made based on how, in practical terms, are the inputs used in the calculations. One should consider the following questions:

Is the organization accurately valued in terms of the current market price?
For what periods and how is the income to be valued?
In which way is the total capitalization to be calculated?
Are these values to be trusted?
What are the growth prospects with regard to revenue and earnings over the period of the investment?
What about the one-time special charges which artificially lower the earnings?
Were they used or ignored in the calculation?
Are these, in fact, one time charges or the company is trying to fool us into thinking so?

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