PE ratio or P/E ratio
Price earnings ratio definition: Price to Earnings ratio or PE ratio (pronounced as P by E ratio) is a ratio of a company's current stock price relative to its per share earnings (profits). For calculating P/E ratio, the earnings are typically the addition of earnings per share (EPS) as reported by company in last four quarters. This is called trailing PE or TTM (trailing twelve months) PE ratio. Sometimes P/E is calculated by taking into account company's expected earnings in next four quarters, this is called as Forward P/E.
The PE ratio is also called as "earnings multiple" as it indicates the number of times the share price is at, as compared to the company.s earnings. It is also referred to as the "price multiple". For non-profitable companies there is no PE ratio.
PE ratio calculation: PE ratio = Market value per share/ Earnings per Share
What is PE ratio?
A high P/E ratio indicates that investors are willing to pay a much higher price as compared to the company's current earnings. This typically happens for fast growing companies where investors are expecting rapid growth in earnings and hence the stock price. However a high PE is also a good indication of a price bubble formed due to stock market exuberance.
It must also be noted that the PE ratio can be used as a basis of comparison for stocks of companies within the same industry. For example, it does not make sense to compare a high growth internet stock to that of a manufacturing stock.
Consider a company that has reported earnings per share (EPS) of $1.2, $0.8, $1.3, $1.7 in the last four quarters and its current price is $120. This company will have a PE ratio of 120/4=30. The average market PE ratio is in the range of 20-25.
Sometimes companies have a very high PE ratio due to a quarter in which the company reported a loss. In the above example if the company were to have earnings of $1.2, -$4 (loss), $1.3, $1.7 and is trading at a price of $120 then the P/E ratio comes out to be 120/0.2 = 600. The 4$ loss could have been due to a one-time charge that the company suffered, in such cases the P/E ratio is sometimes calculated as P/E excluding onetime charges to correctly reflect the company.s operating conditions.
PE ratio of tech companies
Technology companies being high-growth in nature usually enjoy much higher PE ratios. They are expected to earn higher returns for investors, and usually sell at higher valuations. An investor must not rely on the PE ratio alone as a means of making an investment decision, as it could be misleading.
Figure 1: Amazon PE ratio chart Vs Apple PE ratio chart
Take the example of a company like Amazon (Figure 1) whose stock has always enjoyed a high PE ratio (PE ratio has been above 100 since 2007), and compare it with a company like Apple. In spite of its huge historical growth, Apple has always traded at a PE ratio of no more than 20. PE ratio is just a quick guide to check if the stock is fairly valued. High PE stocks could be risky bets, but it always does not mean that the stock is overpriced, if the same can be translated into profitability for the company.
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