Understanding the meaning of and the limitations of price earnings ratio is a key part of the learn trading and investing course.
Lets look at Price Earnings Ratio (P/E).
The ratio is made up of two parts.
1. P = Price per share
2. E = Earnings per Share
(These 2 together form the famous PE Ratio)
As an investor we want to invest in good quality stocks at a reasonable or fair price. The P/E ratio helps us to determine a reasonable price i.e.is the stock cheap or expensive. The best way to illustrate is to show a price earnings ratio calculation.
Let’s say the price of a share in XYZ plc is at the moment is £30.00 and that year it made Earnings per Share of £10.00. We get the price from the FT Newspaper or Yahoo Finance.com and we get the Earnings per share from the company’s annual report/accounts.
This is gives us a P/E ratio of:
Try another example:
Let’s say the price of this particular USA stock at the moment is $24 dollars and this year it made Earnings per Share of 3 Dollars.
What is the P/E ratio?
Essentially you are paying for future earnings. The higher the PE Ratio the more you are paying now for future earnings.
Have a look at the video below which provides a nice explanation of the Price Earnings ratio:
In the next lesson we shall look at the price earning growth (PEG) ratio.