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
What Is A Good PE Ratio?
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.