In today’s post, we’d like to focus our attention on the price to earnings ratio. This is a prospect ratio that calculates a stock’s market value. It does that by the market price per share with the earnings per share. With that in mind, this ratio indicates what the market is likely to pay for a stock, considering the current earnings.
So, why do investors utilize this formula? This contributes to establishing the fair price of a stock. Essentially, they do this by predicting the future earnings per share. In general, companies that have more significant future earnings, are expected to distribute higher dividends or have appreciating stock in the future.
Evidently, though, the actual value of a stock is much more complex, in the sense that it cannot be assessed merely by predicting future earnings. This is the main reason why the price to earnings ratio is often introduced as a price multiple, or earnings multiple. On a different note, investors also turn to this ratio to determine what multiple of earnings a share is worth – more specifically, how many time earnings they inclined to pay.
What Formula Is Used for Calculating the Price to Earnings Ratio?
As for the ideal timing for calculating this ratio, it is at the end of every quarter – more specifically, when the quarterly financial statements are released. Nevertheless, another option most investors opt for is that of calculating the price to earnings ratio at the end of each year, after assessing the financial statements of a company. Either way, in general, the accurate value is the equivalent of the trading value of the stock at the end of the existing period.
Analyzing the Price to Earnings Ratio
The price to earnings ratio points the anticipated price of a share based on its earnings. With that in mind, when the firm’s earnings per share start to grow, so do the market value per share. Fundamentally, a company whose price to earnings ratio is high would mirror positive future performance. This is why investors might be willing to pay more to acquire the firm’s shares.
On the other side, though, if a company has a lower price to earnings ratio, this would mean that its past and future performance is not the best, quite the contrary. As a result, such a firm would be conveyed as a poor investment.
A good thing you should note, though, is that this ratio is insightful only if you want to compare companies that operate in the same industry. Considering that it’s based on the earnings per share calculation, it can be easily manipulated with particular accounting techniques.
We hope that this article addressed most of the questions you had concerning the price to earnings ratio. However, something that’s worth noting is that investors and analysts should utilize more than a singular formula to assess a firm’s financial situation, to get a fair overview.