Learn On Your Own Accounting Entries For Price Earnings Ratio:

Price Earnings (P/E) Ratio or Price-To-Earnings Ratio is one of the more common measure to evaluate the market value of a stock relative to its earnings by comparing the market price per share by the earnings per share. It takes into account the current price of that stock relative to its earnings per share. Simply, the price earnings ratio shows what the market is willing to pay for a stock based on its current earnings. In other words, it's a financial measurement that investors can use to evaluate the future cash flows from an investment in relation to the value of the investment. Many investors view this ratio as the amount of money the market is willing to pay for the current amount of cash flows attributed to each stock.

Analysis of Price Earnings (P/E) Ratio :

It is that financial ratio which is frequently used by the investors to evaluate the fair market value of shares by predicting its future earnings per share. Companies with higher future earnings are usually expected to issue higher dividends or have appreciating stock in the future.

It helps an investor to determine how to cheap or expensive a company's stock is. It determines how many times more that an investor needs to pay for the company's current earnings compared to its share price. Suppose if the share price of a company is Rs. 162 and its EPS is Rs. 9 and P/E is 18. So the investors are willing to pay 18 times for every rupee of the company's earnings.

P/E Ratio helps to compare the stock price of one company with that of another company in the same industry, or stocks of two companies from different industries.

Formula of Price Earnings (P/E) Ratio:

The price earnings ratio formula is calculated by dividing the fair market value per share by the earnings per share.

Price Earnings (P/E) Ratio =Price Per Share
Earnings Per Share

Thus, there are three main factors that can manipulate the Price Earnings per share of a company:

  1. Number of outstanding shares,
  2. Income for a period, and
  3. The market price.

All others equal, the company can manipulate its PE with two of these factors.

Potential investors can make use this equation to calculate past price earnings ratios or estimate future earnings ratio. By using the last period's earnings per share and the market value of shares on the date of issue of the financial statement, investors can calculate the historical Price Earnings Ratio. They can also use the fair market value of share and estimate the future earnings per share to calculate and expected price earnings for the next period by speculating the future price of the stock as well as estimate the corporate profits in the next period. Many investors believe that company's shares with a higher PE ratio, above 25, tend to be overvalued because investors are willing to pay more based on the ratio. Likewise, a stock with a ratio below 8 is often viewed as an underpriced stock.

Limitations Of Price Earnings (P/E) Ratio:
  1. Price Earnings normally relates to previous year. But as stock price fluctuates, a company with good Price Earnings one year may loss in subsequent year and there will no Price Earnings left since earnings disappear.
  2. Even if two companies have the same Price Earnings in the same industry, they may not be equally cheap or expensive. You will need to know which company will have a better earnings growth next year to evaluate one against the other.
  3. The Price Earnings ratio is normally drawn up from income statement wherein, a concern can reflect income from separate head say for example "Other Income" which could be sale of asset (a non-trading income) this could mislead low Price Earnings to innocent investors.
  4. Price Earnings can be easily altered by lowering expenses and inflating net profit.