August 31, 2014

PE Ratio Explained

The Price to Earnings ratio, or PE Ratio allows investors to analyse whether a share of a company is under or overvalued. The ratio itself consists of the following formula; Share Price / Earnings Per Share (EPS) = PE ratio.

So what does it all mean? Putting it into practice helps highlight some of the ratio’s benefits. Let’s assume a company has a share price of 50p, and it’s earnings per share is 10p, therefore its PE ratio will be 5.  A common interpretation is that this PE ratio of 5, means that a company could cover its share price in 5 years in relation to its earnings.

Technically speaking, a lower PE ratio is more favourable and means that the company is ‘cheaper’ and potentially undervalued. However, there are a number of different types of PE ratio that can be used including forward PE (forecast earnings for 12 months), cyclically adjusted PE (averaged earnings over a lengthy period) and Trailing PE (based on earnings for the last 12 months).

It is also difficult to definitively say which PE ratio is ‘high’. It all comes down to investor’s preference, some may not mind a PE ratio of 35 because it may signify a company with good growth prospects. However, some investors may prefer a far lower PE because it will usually entail less risk and could represent great value.

Moreover, the PE ratio isn’t the be all and end all as there are numerous factors that can influence the share price of the company and when the commonly used Trialling PE method is used it doesn’t highlight growth potential of a firm.

As the PE ratio is fairly limited in terms of what it can tell an investor, many now favour the PEG ratio when evaluating the value of stocks. This is because the PEG ratio accounts for forecast earnings growth.