In my recent articles about best and worst performing stocks/shares, I have been reviewing the prospects of those companies and referring to their PE Ratio when talking about their valuation.
PE is an abbreviation for Price to Earnings and is one of the most useful ratios you can use when buying or selling company shares.
It is also very easy to understand and calculate as we will see in this article.
What is a Price Earnings Ratio?
The Price Earnings Ratio is also known as the Price to Earnings Ratio or PE Ratio.
It compares the cost of buying one share of a particular company to the earnings per share of the same company.
What is Earnings Per Share?
The Earnings Per Share is usually abbreviated to EPS and is the total earnings of a company divided by the number of shares the company has.
Earnings is just another word for profits.
EPS figures are always published in the latest annual report and are often reported in the headlines of the latest company results so they are relatively easy to find if you want them.
How To Calculate a Price Earnings Ratio?
To calculate a PE Ratio, you need to divide the share price by the EPS figure.
The number you get from doing this will tell you how many years worth of company earnings you are buying.
Or put another way, how many years it would take you to get your money back if the company continues to make this same profit every year.
Why am I interested in that, you ask?
Well, if we multiply the share price and the EPS figures by the number of shares in the company, we get two other numbers, the Market Capitalization of the company and the total Earnings of the company.
Of course, dividing the market capitalization by the total earnings will also give us the same PE ratio as we have before (because the number of shares on the top and bottom of the fraction cancel each other out).
Sometimes, this calculation may be easier to do if you have those numbers to hand instead of the share price and EPS.
The other reason I mention this, though, is because it is now easier to understand why the PE ratio is so important and so useful.
The PE Ratio is a Valuation Tool
If I were considering buying the whole company, then I would want to understand how much profit (earnings) the company makes.
I would also want to know how many years I would need to continue making those profits for me to get my initial investment back.
This number is the PE Ratio!
By comparing the PE Ratios for different companies, we can get a feel for whether a company’s shares are cheap, expensive or fairly valued.
Essentially, that’s what I was doing in my recent articles.
You might want to take a look at some of them to get a better idea of how useful this PE Ratio can be.
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