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:

  1. How the expected future earnings of the company differ from its current earnings.
  2. The earnings of the company must at least beat inflation.
  3. 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.

This definition is part of the Dictionary of Financial Terms. If you want to receive a notice every time a new definition is published, you can subscribe to Liberta.

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