Price earnings ratio

The price earnings ratio represents the price paid for a share in a company, relative to the earnings or net profit it generates per share. This ratio is used to value companies in absolute and relative terms.

The higher a company’s P/E ratio, the more an investor is paying for each unit of net income. For example, a stock with a P/E ratio of 10 implies that the market is willing to pay 10 times a company’s earnings to own the stock. An investor will pay an expensive price if he expects future earnings to be relatively higher (than companies with a low P/E ratio). Thus growth stocks tend to have higher P/E ratios.

P/E ratios can be compared to determine which securities are undervalued or overvalued. For example, if a firm has a P/E ratio of 10, whereas the average P/E ratio of its sector is 15, it is likely that this stock is undervalued. This ratio varies across industries, and it is therefore only useful to compare the P/E ratios of companies in the same sector. A technology company (characterised by rapid growth) will have a drastically different P/E ratio from a utility company (which is more stable).

P / E = (Market value/number of shares) / annual earnings per share (EPS)