## P/E Ratio (Price-to-Earnings Ratio)

If you want to invest in shares on the stock exchange, it is very useful to look at the P/E ratios (price-to-earnings ratios) of the companies you are interested in.

The P/E ratio of a company tells you how cheap or expensive the current share price of the company is.

You can calculate the P/E ratio of a company with the following formula:

P/E ratio = price per share / annual earnings per share

The *higher* the P/E ratio of a company, the *more expensive* its share price.

### What does the P/E ratio of a company mean?

The P/E ratio is expressed in *years*.

It is the number of years it will take for the after-tax earnings of a share, to be equal to the current purchase price of the share (assuming the earnings remain constant, and ignoring the time value of money).

### What should I consider when looking at a P/E ratio?

In general, there are three main things I try to keep in mind when I look at the P/E ratio of a company:

- How the
*expected future earnings*of the company differ from its*current earnings*. - The earnings of the company must at least beat inflation.
- The
*higher the risk*of the company, the*lower the P/E ratio*must be.

### Current P/E ratio vs. Forward P/E ratio

For the P/E ratio of a company to be meaningful, the expected future earnings of the company should at least be similar to its current earnings.

If there is a good chance that a company’s earnings will dramatically increase or decrease over the next year, it is better to consider the *forward P/E ratio* of the company:

Forward P/E ratio = price per share / expected earnings per share for next year

In general, the lower the risk of a company, the more meaningful its current P/E ratio will be, because the company’s earnings will be more stable.

### Maximum allowable P/E ratio

To start out with your analysis of a company, it is useful to determine a maximum allowable P/E ratio. You can do this by looking at the current rate of inflation.

If the current rate of inflation is 8%, the maximum allowable P/E ratio that will make a company a worthwhile investment can be expressed as:

Maximum allowable P/E ratio = 100% / rate of inflation = 100% / 8% = 12.5

If a company has a P/E ratio that is higher than this value, it means that the returns on your investment is not likely to beat inflation. In other words, you will effectively be making a loss, if you take into consideration the *time-value of money*.

### Higher risk needs lower P/E ratio

The higher the risk of investing in a company, the lower the company’s P/E ratio should be.

A low-risk company that offers consistent returns, consistent dividend pay-outs, good company management and that has a proven track record over a few years, can be a worthwhile investment, even if it has a P/E ratio that is only marginally lower than the maximum allowable P/E ratio.

On the other hand, for a high-risk company to be good investment, where you are less certain of the company’s future performance, the company should have a P/E ratio (or future P/E ratio) that is much lower than the maximum allowable P/E ratio, and thus, offer potential returns that is well above inflation.

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