Category: Finance

What is PE Ratio?

What is PE ratio?

The Price-to-Earnings (PE) Ratio is a valuation metric used to determine the relative value of a company’s shares by comparing its share price to its earnings per share (EPS). It essentially reflects how much investors are willing to pay for each dollar of a company’s earnings.

PE ratio shows how many years it will take to recover the money invested in a company assuming it’s earnings remain constant.

Calculation of PE ratio

The formula for PE ratio is as under:

PE ratio = Price / Earning per Share (EPS)

For example, XYZ ltd. EPS is $ 5 and market price of the share is $ 50. The PE ratio in this case will be 10.

This means that investors are willing to pay 10 times the company’s earnings for each share. In other words, it would take 10 years of the company’s earnings to recover the investment in its shares, assuming constant earnings.

PE Ratio Interpretation

  • High PE Ratio: Often indicates high growth expectations, meaning the company might be perceived as having strong future prospects. However, it could also indicate that the stock is overvalued.
  • Low PE Ratio: Could indicate lower growth expectations or a riskier business model, which may cause investors to discount its value. Conversely, it might signal an undervalued stock.
Type of companiesPE Ratio
High growth companies Typically have a high PE ratio because investors expect future earnings to increase significantly.
High risk companiesOften have a low PE ratio because of the uncertainties or risks associated with their business.
Firms with high reinvestment needsMight also have lower PE ratios as a lot of their profits are reinvested back into the business rather than being reflected in current earnings.

Limitations

The PE ratio can be influenced by a company’s capital structure (debt vs. equity), which might distort its valuation.

It may not always provide a complete picture, especially when comparing companies with different levels of debt or capital investment needs.

For a more comprehensive assessment, other multiples like EV/EBITDA (Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization) are often used, as they neutralize the effects of capital structure differences.

The PE ratio, while useful, should be considered alongside other financial metrics to get a full understanding of a company’s value.

Rule of 72

The rule of 72 is used as rule of thumb for estimating an investment’s doubling time.

The formula of Rule of 72 is

T  =  72/r

Where

r  = rate of interest / year

T = number of periods required to double an investment’s value

For example, we want to know what is the time required to double investment @ 6% rate of interest.

It will take 12 years ( T = 72 / 6) to double the interest.

So, next time someone asks you to tell how much time an investment at a certain rate of interest takes to double your money, use of Rule of 72 can be a quick handy tool and you do not need our calculator or laptop.

It may be noted that Rule of 72 & other variations i.e. the rule of 70 and the rule of 69.3 gives approximate time an investment takes to double the investment.