P/E ratio (PE ratio, Price to earnings ratio)

P/E ratio
= Market price of a share / Earnings per share (EPS)

= Market Capitalization / Earnings

where

Market Capitalization = Number of shares outstanding * Market price of a share

For calculating the earnings there are several variations.

1. Following measure of Earnings are generally used

Earnings after tax (EAT) {most commonly used}

Earnings before tax (EBT)

Earnings before interest and tax (EBIT)

Earnings before depreciation interest and tax (EBIDT)

Earnings before depreciation interest tax and amortization (EBIDTA)

2. For which period the earnings should be taken for?

Generally the earnings are for a period of one year. Now since prices change on every trading day and can be tracked the earnings can be measured efficiently only for a larger period of time generally a quarter. Another question which arises is which period should be considered. There are two variations to this:

TTM (trailing twelve months) – for past 4 quarters

Annual – For last financial year

Leading – Using projected EPS

Can P/E ratio be negative?

Sometimes companies earn zero profit or even run into losses. Is the P/E ratio significant there? For knowing this we have to find out the purpose of finding the P/E ratio.

What is the purpose of P/E ratio?

It shows how much the investors are willing to par for one dollar of company’s earnings. When compared with the industry average and leader we can find out the level of confidence that investors have in the company. But P/E ratio alone is not a sufficient measure to arrive at any conclusion about the stock.

What are the limitations of P/E ratio?

Inability to capture non-monetary aspects.

No standard for using a measure of earnings

Doesn’t cover the past growth and the future growth projection

Can be interpreted in different ways

A one period exceptional income can distort the picture