Price to Earnings ratio (P/E ratio) also called earnings multiple of a stock refers to the measure of the price paid for a share compared to the net income or earnings of a company. The P/E ratio reflects the capital structure of the company. A higher P/E ratio means the investors are paying more for each unit of net income; therefore, the stock is more expensive in relation to one with a lower P/E ratio. The P/E ratio expressed in years, shows the number of years of earnings which would be required to pay back purchase price ignoring inflation. The P/E ratio can also show current investors demand for a company share. The reciprocal of the P/E ratio is the earnings yield. Companies with high P/E ratios are more likely to be considered risky investments than those with a low P/E ratio. If the price of a share rises and the EPS remains constant then the P/E multiple will rise, if the share price falls with a constant EPS the P/E falls. Companies that are not profitable or those companies which have negative earnings don’t have a P/E ratio.
Types of P/E ratio
There are three main types of P/E ratio:
• Trailing P/E ratio - the price/ earnings ratio for the last four quarters or of one year.
• Projected or forward ratio - the price/ earnings for the projected next four quarters or one year.
• Rolling P/E ratio - the price/ earnings ratio for the last two quarters and the projected next two quarters.
It is said that the most accurate P/E ratio is the trailing P/E since the forward and rolling P/E based on projected figures.
Importance of P/E ratio
The P/E ratio indirectly includes key fundamentals of a company such as future growth and risk. It basically takes into account the following aspects:
Past Performance – a company with an established track record would have a higher P/E relative to a company which has had an unpredictable performance.
Future Growth: One of the most important factors built into the P/E ratio. Once the company is based on high growth it will have higher P/E than a low growth companies within the same industry.
Risk: P/E ratios are highly impacted by the company’s capital structure. Leverage affects both earnings and share price in a number of ways: leveraging of earnings growth rates, bankruptcy risk and its tax effects and impact. Thus, lower the leverage, higher the P/E ratio and vice versa. Therefore, higher capital intensive industries have lower P/E’s than those of lower capital intensive industries.
Corporate Governance: Companies with strong corporate governance will have higher P/E than its sector group.
Dividend Pay-out: Companies with high and constant dividend payments have a higher P/E ratio mainly because it demonstrates the firm’s fundamental strength and its commitment to rewarding its shareholders.
Economic Cycle: Sectors which are affected by economic cycle (recessions and booms) usually trade at lower P/E’s than other sectors who are less influenced by these changes.
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