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Price to Earnings (P/E) Ratio - Finance Glossary The Price to Earnings (P/E) ratio compares a corporation's current stock price to the earnings per share that it yields. For instance, if a corp's stock is currently trading for $46 and earnings per share over the last 12 months have been $2, then the P/E ratio is $46 / $2 = 23. In general, the formula for Price to Earnings Ratio is:
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The denominator, Earnings Per Share, is derived from the financial statements of the company over the last 4 quarters. Also, the EPS can be derived from estimates of the 4 upcoming quarters. If you buy a stock at a P/E ratio of 15, this means it will take you 15 years of earnings derived from that stock in order to cover up your original investment. In other words, you'll get a "payback in 15 years." Consider a corp that earned $15 million last year and had earnings per share of $15 with 1.5 million shares outstanding. If the current trading price of the stock is $150, this means the firm's P/E Ratio is = $150 / $15 = $10. This can also mean the investors are willing to pay $10 for every $1 of earnings derived from that stock. Drawbacks of Using the P/E Ratio 1) The Price to Earnings Ratio is based on future estimates of earnings, example the upcoming 4 quarters of earnings to calculate the EPS (Earnings per Share). With a very volatile and fast changing economy that we are currently in, estimates of future accounting earnings should be taken with a grain of salt. 2) The Accounting Multiplier used is a debatable issue. Should analysts use the industry average, expected growth return model or Weighted Average Cost of Capital model? 3) Since the Earnings Per Share is sometimes calculated using the last 4 Quarter's Earnings (old data), this may not fully represent the present condition of the firm. Price to Earnings Ratio calculated in this manner is also known as a "Trailing P/E." Interpretations of Price to Earnings (P/E) Ratio
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