PE Ratio Explained to Beginners

The price earning ratio is a tool that comes as a part of a bigger ratio analysis used to measure corporate value. The method is also utilized with the aim of examining specific financial data of a particular company in terms of stocks and bonds trading. Moreover, the PE ratio makes it possible to identify the current financial state and health of a given enterprise.

Ratio analysis generally involves several vital aspects that are divided into specific categories. They include liquidity, market value, profitability, solvency, and debt management.  In this article, we will define the price earning ratio meaning as well as ways to calculate it and interpret it when trading in the financial market.

How to Calculate PE Ratio

What is the price earning ratio? It is the illustration of the relations between a company’s earnings and stocks. Traders will have a chance to observe current stock prices in their derivation. To calculate the PE ratio, it is necessary to quantify EPS (earnings per share). In order to calculate EPS, you need to use the formula:

• EPS = Net Income / Number of Outstanding Shares

When you have the EPS value, you can calculate PE ratios using the formula:

• PE ratio = Current Price of the Stock / EPS.

Mow, when we know how to calculate price ratio, let’s see the way it can be utilized and interpreted in the financial market.

PE Ratio Interpretation and Application

As you have already understood, the price earning ratio makes it possible to evaluate the company’s worth when taking into account its current net income and stock price. However, sometimes the stock price does not reflect the relevant earning of a given company. 

In other words, a company with a lower PE ratio may potentially seem more like a bargain when compared with the one with a higher price ratio. On the other hand, a company with a higher PE ratio definitely comes with greater profit potential in terms of long-lasting investments and future earnings. This is what makes the tool so important for investors.

Limitations of Price Earning Ratio

The tool comes as a niche-specific instrument. Besides, it can be used when comparing one company to another. The good news is that both enterprises can represent different sectors. On the other hand, the tool can be quite misleading when used under specific circumstances:

1. The industrial sector is overvalued – it happens when investors are too optimistic about the company making it inflate the stock price resulting in what professional investors call “a bubble”.
2. Periodically occurring inflated earnings – let’s say, an investor gets an abnormally high income from a corporate asset. In this case, the PE ratio will be depicted in an unrealistic fashion.
3. The business has a cyclical nature – it is a common situation when different businesses operate in a cyclical environment. It may refer to the automotive industry, real estate, energy production, and other crucial sectors. They all generate earnings utilizing the concept of the rotating basis.

When any of the above-mentioned situations take place, the price earning ratio can be depicted irregularly. For this reason, investors should use a bunch of additional economic factors to evaluate the company’s worth and health rather than rely only on the PE ratio.

The Bottom Line

The price earning ratio is a good tool whenever you want to compare and contrast two companies, their stocks, financial health, and some other crucial points that can define your potential future earnings. However, the tool does not guarantee success, as it comes with some specific limitations depending on the situation in the sector. To make the most of the tool you need to perform in-depth corporate and market research to observe stocks’ potential and value from different angles.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.