The PE ratio: Delving into the most common way to value a share

Julie Brownlee, Fsp Invest, 25 Aug. 2015

Tags: pe ratio, what is the pe ratio, trailing pe, forward pe, how to value a share, financial ratios

There are a wide number of different financial ratios investors and analysts use to value a share. By far the most common is the price earnings (PE) ratio.

So what exactly is the PE ratio? And what’s the best way to use it?

Read on to find out…

What is the PE ratio?

To calculate a company’s PE ratio, you simply divide its share price by its current earnings per share (EPS).

PE ratio = Current share price / current EPS

The resulting figure it the value of a company as a multiple of its profits after tax. As this calculation uses historic data from a company’s most recent accounts, it’s known as the trailing PE ratio.

For example, let’s say Company ABC has a share price of 1,000c and EPS of 100c. This means Company ABC has a ratio of 10. In other words, 10 times its current earnings.

In some instances, investors and analysts use a company’s forecast earnings to calculate the PE ratio. This is known as the forward PE ratio.

How to use the PE ratio

The higher a company’s PE ratio, the more expensive the share is.

For instance, if a company is growing its profits rapidly, it will have a high PE ratio. Investors are willing to pay a higher multiple for the company’s earnings today as they expect them to grow quickly.

On the other hand, a low PE ratio indicates a share is cheap. It can also be an indication that the company won’t grow at a decent rate or it has an uncertain outlook.

You can’t use the PE ratio is isolation to weigh up a share. You’re best to use it along with other valuation ratios to get a good idea of its value.

It’s also a good idea to compare a company’s PE ratio to companies in the same sector and to the PE ratio of the sector.

So there you have it. Delving into the most common way to value a share, the PE ratio.

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