Stock market 101: The PE ratio

Julie Brownlee, Fsp Invest, 23 Jun. 2015

Tags: pe ratio, price earnings ratio, what is the pe ratio, using the pe ratio, financial ratios

If you check the financial information of a listed company online or read market commentary, you’ve likely come across reference to the price earnings (PE) ratio.

So what is the PE ratio? And how should you use it?

Read on to find out…

What is the PE ratio?

The PE ratio is simply a company’s current share price divided by its current earnings per share (EPS). In other words…

PE ratio = Current share price / Current EPS

The PE ratio tells you the value of a company as a multiple of its after -tax profits, Money Week explains.

For example, if a company’s share price is 200c and its EPS is 20c, its PE ratio is 10 (200c/20c). Or ten times its current earnings.

In some instances, investors and analysts use a company’s forecast earnings to work out the PE ratio. This gives you the forward PE ratio. Other times, they use a company’s historical earnings to work it out. This is known as the trailing PE ratio.

These are both methods of valuing shares.

How to use the PE ratio

Broadly speaking, the higher a PE ratio, the more expensive a share is. You’ll tend to find companies with high PE ratios have fast growing profits.

Investors will pay a higher multiple of today’s earnings as they expect the company to continue growing rapidly and reward them for that.

When a PE ratio is low, it can suggest a company’s cheap. It can also infer that a company doesn’t have good growth prospects or its outlook is uncertain.

Investors will pay a lower multiple due to these reasons.

As with other financial ratios, you shouldn’t use the PE ratio alone to value shares.

When looking at the PE ratio of a company, it’s a good idea to compare it to the PE ratio of its sector and the broader market, along with its competitors.

So there you have it, the PE ratio.

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