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What is the PE ratio

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As you probably know, there are a variety of different ratios that investors may use to value a business. Today, we’re going to take a look at the price-to-earnings ratio or the P/E ratio in short.

What is the P/E ratio?

The price-to-earnings ratio is a formula that investors use to value businesses. This ratio calculates the company’s current share price divided by its earnings per share. A high P/E ratio could indicate that the stock of a company is overvalued. Most of the time, a high P/E ratio simply suggests that investors are expecting high growth rates in the future.

Bear in mind that businesses that lose money (or do not have earnings) do not have a P/E ratio. Negative earnings will amount to a negative price-to-earnings ratio which is not very useful.

Calculation and examples

Calculating the price-to-earnings ratio is not very hard to do. You have to take the current market value for each share and divide that by the earnings per share.

PE Ratio

First, let’s take a look at a hypothetical example. We have a company XYZ with a share price of $100. This company has profits of 10 billion dollars and 1 billion outstanding shares. We can now easily calculate earnings per share: $10billion/1billion = $10. After that, The P/E ratio of company XYZ will equal 10x: $100/$10.

Two varieties

There are two commonly used varieties of calculating the P/E ratio. One uses forward earnings, the other one uses trailing earnings. The forward price-to-earnings ratio uses future earnings guidance. Therefore, this means that estimated earnings are used. As a result, you could argue that this provides a better picture. But, Keep in mind that estimated earnings will not always be equal to the actual results.

The trailing P/E ratio relies on the performance over the past 12 months. As a matter of fact, this is also the most used one. Here, we only use actual numbers. Assuming the company reports earnings accurately. In addition, Trailing profits-to-earnings has its own shortcomings as well. For example, past performance is, of course, not an indication of possible future results.

What do we learn from the price-to-earnings ratio?

In conclusion, the price-to-earnings ratio is one of the most used stock analysis tools. It can reveal if a stock is potentially overpriced/undervalued when compared to other companies in the same industry or a benchmark like the S&P 500.

When you take it down to the basics, the P/E ratio actually shows how much investors are willing to pay for every dollar of current earnings

Do you think that I have missed something? Please leave your comments in the section down below! In addition, If you are interested in my current portfolio, check it out here!

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