The P/E ratio (price-to-earnings ratio) of a stock is a measure of the price paid for a share relative to the income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income. It is a valuation ratio included in other financial ratios. The reciprocal of the P/E ratio is known as the earnings yield.
P/E Ratio = Price Per Share/Earnings Per Share
The price per share is the market price of a single share of the stock. The earnings per share (d is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. The earnings per share (EPS) used can also be the "diluted EPS" or the "comprehensive EPS".
For example, if stock A is trading at Rs.24 and the earnings per share for the most recent 12 month period is Rs.3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of stock A is paying Rs.8 for every rupee of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio (usually shown as Not applicable or "N/A"); sometimes, however, a negative P/E ratio may be shown.
By comparing price and earnings per share for a company, one can analyze the market's stock valuation of a company and its shares relative to the income the company is actually generating. Investors can use the P/E ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal, it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, companies, and time periods may be misleading.
Determining share prices
Share prices in a publicly traded companyare determined by market supply and demand, and thus depend upon the expectations of buyers and sellers. Among these are:
*The company's future and recent performance, including potential growth;
*Perceived risk, including risk due to high leverage;
*Prospects for companies of this type, the "market sector".
By dividing the price of one share in a company by the profits earned by the company per share, you arrive at the P/E ratio. If earnings move up in line with share prices (or vice versa) the ratio stays the same. But if stock prices gain in value and earnings remain the same or go down, the P/E rises.
The price used to calculate a P/E ratio is usually the most recent price.
The earnings figure used is the most recently available, although this figure may be out of date and may not necessarily reflect the current position of the company. This is often referred to as a 'trailing P/E', because it involves taking earnings from the last four quarters.
Variations:
The 'forward P/E' uses the estimated earnings going forward twelve months.
'P/E10' uses average earnings for the past 10 years. There is a view that the average earnings for a 20 year period remains largely constant, thus using P/E10 will reduce the noise in the data.
(See more about P/E Ratio on next Sunday)
