Price Earnings Ratio (PE Ratio)


Price Earnings Ratio (PE Ratio):

Definition:

Price earnings ratio (P/E ratio) is the ratio between market price per equity share and earning per share.

The ratio is calculated to make an estimate of appreciation in the value of a share of a company and is widely used by investors to decide whether or not to buy shares in a particular company.

Formula of Price Earnings Ratio:

Following formula is used to calculate price earnings ratio:

Price Earnings Ratio = Market price per equity share / Earnings per share

Example:

The market price of a share is $30 and earning per share is $5.

Calculate price earnings ratio.

Calculation:

Price earnings ratio = 30 / 5

= 6

The market value of every one dollar of earning is six times or $6. The ratio is useful in financial forecasting. It also helps in knowing whether the share of a company are under or over valued. For example, if the earning per share of AB limited is $20, its market price $140 and earning ratio of similar companies is 8, it means that the market value of a share of AB Limited should be $160 (i.e., 8 × 20). The share of AB Limited is, therefore, undervalued in the market by $20. In case the price earnings ratio of similar companies is only 6, the value of the share of AB Limited should have been $120 (i.e., 6 × 20), thus the share is overvalued by $20.

Significance of Price Earning Ratio:

Price earnings ratio helps the investor in deciding whether to buy or not to buy the shares of a particular company at a particular market price.

Generally, higher the price earning ratio the better it is. If the P/E ratio falls, the management should look into the causes that have resulted into the fall of this ratio.

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