Price earnings (P/E) ratio

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.

Formula:

The formula of price earnings ratio is given below:

price-earning-ratio-img1

A D V E R T I S E M E N T S

Example:

The market price of an ordinary share of a company is $50. The earnings per share is $5. Compute price earnings ratio.

Solution:

=$50 / $5

= 10

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.

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7 Comments on Price earnings (P/E) ratio

  1. Ria Louise Recana

    I understand this better than my Instructor’s. Thank you. It is a great help for self studying. KUTGW.

  2. Gaurav Chhibba

    Dear Experts

    Please advise me:- as per your above interpretation if p/e of company is 6 and industries p/e is 8 ,thus it means companies share price is undervalued .

    So this company is better for invest or not,please explain we have to invest in which company which is undervalued or which is overvalued.

  3. frieda

    yes is undervalued, the company is not better for investors compared to industry and yes invest in an overvalued industry.

  4. Syed Nasif Fuad

    common stock:$2.5 par,100,000 shares authorized, shares issued and outstanding in 2015: 76,262 and in 2014: 76244
    common stock in balance sheet in 2015- $191,000 and in 2014- 190,000
    earnings per share- $2.90
    Price/Earnings (P/E) ratio???

  5. aziza edris

    Total earning Br 200,000 number of equity shares(Br 100 each 20,000) dividend paid br 100,000 then P/E ratio 10 return investment 15%. The firm is expected to maintain its rate of return on new investment.also find out what should be the EP ratio at which the dividend policy will have no effect on the value of the shares will your decision change if the PE ratio is 7.25 and interest of 10%?

  6. ABC

    How to determine P/E ration when price range ( $60-$80) is given?

  7. Kevin odhiambo

    Thanks soo much,,got to learn more about earning per share,,

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