The PE ratio: The ins and outs of one of the most popular financial ratios

Julie Brownlee, Fsp Invest, 17 Nov. 2015

Tags: pe ratio, price earnings ratio, what is the pe ratio, how to use the pe ratio, investing, investing in shares,

If you’re new to investing, you’ll no doubt have already come across the PE ratio. It’s one of the most cited financial ratios used in the investment realm.

So what exactly is the PE ratio? And what does it mean to you as an investor?

Read on to find out…

What is the PE ratio?

The price earnings (PE) ratio shows you the value of a company as a multiple of its after -tax profits.

The PE ratio of any share is easy to come by, but here is how you can work it out…

PE ratio = Current share price / earnings per share (EPS)

Let’s say Company ABC’s share price is 100c and its earnings per share is 10c. This gives it a PE ratio of 10 (100c/10c). This means Company ABC is trading at ten times its current earnings.

Some analysts and investors also work out what is known as the forward PE ratio. To calculate this, you use forecast earnings for a share.

You can also work out the trailing PE ratio of a share by using its historical earnings.

How to apply the PE ratio

Broadly speaking, the higher the PE ratio, the more expensive the share.

For instance, if you have a company that’s growing very quickly. Investors will be happy to pay a higher PE ratio now based on today’s earnings as they expect earnings to grow rapidly into the future.

On the other hand, the lower the PE ratio, the cheaper the share is.

But there may be reasons for a share trading on a low PE ratio. For instance, the company may have very poor growth prospects or there is uncertainty surrounding its future.

You can use the PE ratio to help you weigh up a share you want to invest in. If, for example, you’re looking for undervalued shares, by looking at PE ratios, you can investigate prospective shares further.

So there you have it. The ins and outs of one of the most popular financial ratios.

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