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What Is PE Ratio Or Price Earnings Ratio

The PE Ratio or price earnings ratio or price to earnings ratio is the same. Value Investors like to use this valuation method to assess what the market is willing to pay for a stock based on its current earnings. A value investor can use this ratio plus other indicators to assess if a company’s stock price is overly priced or undervalued.

We often use this PE ratio to evaluate what a stock’s fair market value should be by predicting future earnings per share. Companies with higher future earnings are usually expected to issue higher dividends or have higher capital gain in the future stock price. A stock price can be also affected by the market speculation and demand.

As value investors, the PE ratio helps us to determine how much we should pay for a stock based on its current earnings. This is why the price earnings ratio is also often called a price multiple or earnings multiple. Investors use this ratio to decide how many times earnings they are willing to pay.

How To Calculate PE Ratio

Find the Earnings per share. Financial analysts generally use the trailing PE ratio. In this case, you calculate EPS by taking a company’s net income over the last four quarters (twelve months), account for any stock splits, and then dividing by the number of shares outstanding

What Is A Good PE Ratio?

In general, a PE ratio less than 10 can possibly infer a stock is undervalued. But there are exceptions to certain industries such as financial institutions and banks. If earnings per share of $2 and the stock is selling for $20 per share, the PE ratio is 10. For me, I consider a PE ratio of 10-13 to be ok.
If you would like to assess how is the global market performance? Perhaps a good gauge is by looking at the PE ratio of S&P 500. As of 16 March 2018, the PE ratio of S&P 500 is approximately about 25.69. If this hits 40, it may be a red alert to exit the market first.

What Are The Limitations of PE Ratio?

Comparison of Companies

PE ratio is useful if comparing companies of the same industry. Valuations and growth rates of companies may often vary wildly between industries. Different companies have different business models and they earn their revenue in different timelines and ways.

For example, the PE ratio of a telecommunications company and an energy company may lead one to believe that one is clearly the superior investment by looking at which ever is lower in PE Ratio. But this is not a good assumption and it may not be always correct.

What Can Also Affect PE Ratio?

Certainly. A company’s debt can affect both the prices of shares and the company’s earnings. How much does a company leverages on debt can also affect its P/E ratios as well. The one with more debt will likely have a lower P/E value than the one with less debt. However, if business is good, the one with more debt stands to see higher earnings because a good leverage of debts could possibly help the company to grow her business much faster, hence to generate more revenue in a shorter period of time.

Another important limitation of price earnings ratios is one that lies within the formula for calculating P/E itself. Companies may also manipulate their figures to have their price to earnings ratio looks good. Hence, its accuracy does rely on accurate inputs of the market value of shares and of accurate earnings per share estimates.

At times, you may bound to see an extremely high price earnings ratio due to market speculation. Or you can find an extremely low price earnings ratio which may be due to extra-ordinary gain during the financial year. Therefore, you need to know that PE Ratio is useful from value investing perspective but it is not the only key indicator.

Do your own due diligence. Or simply attend our value investing seminar to know a systematic approach towards a smart value investing approach.

Value Investing Singapore

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