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The Price to Earnings ratio (P/E ratio)
is a
valuation ratio of a company's current share price compared to its
per-share earnings. Even if
Discounted Cash Flow is a superior method to value a company,
sometimes investors prefer to use simpler methods.
The P/E ratio is used for measuring market
performance and can be calculated as:
P/E ratio calculation: Market Value per Share :
Earnings Per Share normally for a twelve
month period.
Often the P/E ratio is used,
because it is so easy to grasp: If you buy stock at a P/E ratio
of 10, say, this means it will take 10 years for the company's earnings to add
up to your original investment - 10 years to "pay you back".
For example, a company that earned $10M
last year, with a million shares outstanding, had earnings per share of
$10. If that company's stock currently sells for $100 per share, it has a
P/E of 10. Stated differently, at this price, investors are willing to pay
$10 for every $1 of last year's earnings.
The
price to earnings (P/E ratio) assumes that the corporation will be
worth some multiple of its future earnings. This method has at least two
drawbacks:
1. it is based on earnings, accounting
profits, which are not a good indicator of actual value creation for
shareholders - more.
2. what multiplier should be used? The
industry average? Often corrections are made based on: the company's
expected growth, the rate of return on new capital and the costs of
capital (WACC)
Book: Steven M. Bragg - Business Ratios and Formulas : A Comprehensive
Guide - 
Book: Ciaran Walsh - Key Management Ratios -
Compare with the P/E Ratio:
Market Value Added |
EBIT |
EBITDA |
Economic Margin |
Return on Equity |
TSR
| PRVit
More valuation methods
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