Price earnings ratios (P/E ratio) measures how many times the earnings per share (EPS) has been covered by current market price of an ordinary share. It is computed by dividing the current market price of an ordinary share by earnings per share.
The formula of price earnings ratio is given below:
The market price of an ordinary share of a company is $50. The earnings per share is $5. Compute price earnings ratio.
=$50 / $5
The price earnings ratio of the company is 10. It means the earnings per share of the company is covered 10 times by the market price of its share. In other words, $1 of earnings has a market value of $10.
Use of P/E ratio:
P/E ratio is a very useful tool for financial forecasting. It gives information about the amount that the investors are willing to invest in the company to earn $1.
It also helps in knowing whether the market price of share is reasonable or not. For example, the market price of a share of XY Limited is $60 and the earnings per share is $10. The price earnings ratio of similar companies in the same industry is 8. It means the market value of a share of XY Limited should be $80 (i.e., 8 × $10). The market value of XY Limited is, therefore, under valued by $20. If the P/E ratio of similar companies is $4, the market value of a share of XY Limited should have been $40 ($4 × $10), thus the share is over valued by $20.
A higher P/E ratio is the indication of strong position of the company in the market and a fall in ratio should be investigated.