Uncovering financial ratios: What you need to know about the PE ratio

Julie Brownlee, Fsp Invest, 27 Aug. 2014

Tags: pe ratio, price earnings ratio, what is the pe ratio, financial ratios, what does the pe ratio show, earnings yield,

When it comes to investing in shares, by far the most quoted financial ratio is the price earnings (PE) ratio.

So what exactly is the PE ratio? What does it tell you? And how can you use it?

Read on to find out…

What is the PE ratio?

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

The PE ratio shows you the value of a company expressed as a multiple of its after -tax profits.

For example, if Company ABC is trading on a share price of R100 and its EPS is R10, the company has a PE ratio of 10. In other words, ten times its current earnings.

What is the forward PE?

When some investors calculate the PE ratio, they use a forecast of a company’s EPS. This is the forward PE ratio.

On the other hand, the PE ratio calculated above, using historical earnings is the trailing PE ratio.

You can use both of these PE ratios to value shares. And you can find both of these PE ratios on different financial sites.

How to use the PE ratio

The bigger the PE ratio is, the more expensive a share appears to be. You usually find a high PE ratio with companies that have fast-growing profits.

Companies with low PE ratios can show that a share is cheap. But it can also be a reflection of a poor growth prospect for a share or its outlook is uncertain.

How to use the PE ratio to give you the earnings yield

The inverse of the PE ratio is the earnings yield. In other words, if a company had a PE of 10, its earnings yield would be 1/10 or 10%.

If you’re looking to uncover bargains, it can sometimes pay off to look for low PE ratios and high earnings yields.

So there you have it, what you need to know about the PE ratio.

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