Finance articles

Price to Earnings Ratio

The most popular ratio used to assess the value of the equity is the company’s price equity ratio abbreviated as P/E ratio. It is calculated as the ratio of the firm’s current stock price divided by the earnings per share (EPS). The inverse of the P/E ratio is referred to as the earnings yield. Clearly the price earning and the earnings yield are required to measure the same thing.  In practice earnings yield less commonly stated and used than P/E ratios.

P/E Ratio=  Market Value per Share/ Earnings per Share (EPS)

Factors that Influence a Company’s P/E Ratio

The P/E ratio used in the business valuation is influenced by the following factors:

1. P/E ratios for a group of companies tend to change little from one period to the next. Therefore an investor cannot expect a dramatic change in the future P/E ratios. The future level of the P/E ratio can be viewed as the function of the current P/E ratios or the average P/E ratio over the same period of time.
2. The P/E ratio is a function of future expected earnings the higher the growth rate of earnings the higher will be the P/E ratio. An investor will be willing to pay a higher price forth-current earnings if the earnings are expected to grow at a much higher rate.
3. A normal P/E ratio for the market is difficult to determine. A normal P/E ratio is established for each company but it can be compared to the market P/E to give some idea of risk. The higher the P/E ratio the higher is the risk. This is true inspite of the fact that the investors are ready to pay more.
4. Inflationary conditions tend to reduce the P/E ratios.
5. Higher interest rates tend to reduce the P/E ratios.
6. The level of P/E ratio is not an absolute one but a relative one.
7. Speculative companies and cyclical companies tend to have a lower P/E
8. Growth companies tend to have a higher P/E
9. Companies with larger portion of debt tend to have a lower P/E
10. A company that tends to pay a higher dividend tend to have a higher P/E
11. P/E ratios can change radically and suddenly because of change in the expected growth rate of earnings. Therefore the greater the expected stability of the growth rates the higher the P/E ratio.
12. An investor should examine the trend of the P/E ratio over time for each company.
13. P/E ratios vary by the industry.