The price-to-earnings ratio (P/E Ratio) gives a valuation of a company’s current share price relative to its earnings per share. Price multiple or earnings multiple are other names of P/E ratio.

The general idea is that you can use the ratio to analyze the performance of different companies. You can also compare a company’s performance relative to its past performance. The P/E ratio gives you a sound basis to determine whether a stock is undervalued, overvalued, or it’s uncertain.

To get a balanced picture of the company’s values, you should look at two the types of P/E ratio:

Trailing P/E: It’s frequently quoted since it deals with existing data. It uses the most recent, 12 months of earnings in its calculations.

Forward P/E: It’s about expectations of earnings in the next 12 months. It may seem better than the Trailing P/E since it looks into the near future. However, it’s considered an estimate that may or may not prove accurate. Most investors avoid suing it for that reason.

How to Calculate P/E Ratio

To calculate price-earnings ratio, use the following formula:

P/E = Market Value per Share/Earnings per Share.

You’ll go through a multi-step procedure to get the earnings per share. First, you’ll get the total value of a company’s outstanding shares (from the company’s reports or records), and divide it by the outstanding shares.

Example:

If a company’s total profit is $20billion, and has 10 billion outstanding shares, to get the earnings per share, divide the company’s total profit by the number of its outstanding shares, i.e. $20/10 = $2 in earnings per share. After that, you need to take a look at the current stock price by multiplying the company’s total profit and its earnings per share, i.e. $20 billion*$2= $40 billion. Plug into the formula of calculating P/E= Market Value per Share/Earnings per Share. Therefore, $40 billion/$2=20. In this case, the P/E is 20.

Luckily, you don’t have to calculate the ratio by yourself. There are many commercial sites with data points of stocks that have the P/E ratio. You can check data points if you have an investing app or an online self-directed trading account.

How Do You Translate the P/E Ratio

The easiest way to translate the P/E ratio is that an investor is willing to specific amount for $1 in current earnings. From the example above, a P/E of 20 means that investors are likely to pay $20 to receive $1 in current earnings.

How Does the PE Ratio Matter for Personal Finance

Investors look at a company’s P/E ratio to determine whether to invest. The rate shows the extent of growth investors can expect from companies they choose to invest. A high rate indicates that investors are paying more per share than the company is earning, which is common in start-up companies with a lot of investments. Often, a P/E ratio of no more than 11 is thought-out as the best in dividend stock market. Many markets have low ratio. A low ratio shows that the company’s growth is slower, but it doesn’t automatically translate to a downfall. It may mean that the company has a stable market share. Let’s get to why the P/E ratio matters for personal finance.

Past Performance

As an investor, you can use the P/E ration to track the performance of a company before investing in it. A company with a proven track record may have a higher P/E in comparison to a company with an erratic past performance.

High P/E Ratio for Future Growth

To an investor or interested parties, this is the most vital factor built in the P/E ratio. Companies with high sales and earnings will have a bigger P/E than low growth companies in the same industry.

Corporate Governance

You want to invest in a company whose corporate governance is strong. That way, you’ll have confidence since the company can efficiently and effectively raise capital. Such a company will dictate a higher P/E that its peers. For instance, Infosys has a historical command of bigger P/E than its peer group, thanks to its strong corporate governance.

Dividend Payout

Using P/E ration, you can be able to determine a company’s dividend payout. A company with P/E dictates a high but stable dividend for its investors. Reason being, it shows the fundamental strength and the commitment of a company to reward its shareholders.

Economic Cycle

You can be able to tell industries or companies affected by the economic cycle since they usually trade at a lower P/E, as compared to defensive sectors or companies. For example, you may opt to invest in FMCG and Pharma sectors as they are less likely to be affected by the economic cycle as opposed to investing in Textile and Capital Goods sectors.

Conclusion

You may consider using the P/E ratio as its prima facie looks simple and effective method. However, you might encounter difficulty in finding trading companies for comparison. It’s difficult for any company to want to intentionally manipulate the numbers to look better, with the primary aim of deceiving investors. They’ll have to work strenuously to ascertain manipulation for all metrics. It’s the reason why the P/E ratio continues to be one of the centrally referenced points of data in analyzing a company by investors. In order to invest wisely so as not to take an excessive risk now, consider the benefits as discussed.

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