Price earnings ratio (also known as price to earnings ratio or P/E ratio) is the ratio of market value of the company’s ordinary (common) share to earnings per share. It shows the number of times the market price of a company’s share is higher than its earnings per share for the last twelve months. It is therefore also termed as earnings multiple and price multiple.
P/E ratio is the market value per share divided by the earnings per share. It is the most important measure used by investors to judge the worth of the company.
The P/E ratio should be compared with the share market as a whole, of other companies in the same industry, and of the company in the last few years.
If price earnings ratio is high, it means the share is selling in the market at a good price. Generally, there is an acceptable price earnings ratio that prevails in the market. If a company’s earnings per share gets higher, but its price earnings ratio remains constant, the market price of its share goes up.
The annual earnings per share ratio of John Trading Concern is 2.8 (as calculated on the “earnings per share (EPS) ratio” page) and the market value of its share is $25. Calculate price earnings ratio of the company.
Price earnings (P/E) ratio = $56/2.8
= 20 times
The P/E ratio of the company is 5.36 which means that the market price of an ordinary share of the John Trading Concern is 20 times higher than the earnings per share for the period of last 12 months. In other words, we can say that an investor who buys the shares of John Trading Concern is willing to pay $20 for each dollar of earnings.
A high price earnings ratio indicates that the investors are willing to buy the shares of the company at a higher price because they anticipate a good financial performance of the company in future and a low ratio indicates the opposite. As stated earlier, there is usually an acceptable range of this ratio for the purpose of investment. Weather a company’s price earnings ratio is acceptable or not for the purpose of investment can also be concluded by comparing it with that of other similar companies or the industry’s average ratio.