Valuation Metrics: Price-Earnings Ratio (P/E)
Let's Learn about Price-Earnings Ratio (P/E)!
Today, we will explore the concept of Price-Earnings Ratio (P/E) and what it means for companies. It's like figuring out how much you are willing to pay for a toy based on how much fun you think you'll have with it!
Price-Earnings Ratio (P/E Ratio)
The Price-Earnings Ratio (P/E Ratio) helps us understand if a company's stock is a good buy or not. It is like checking if a toy's price is fair compared to how much fun it can provide.
Formula:
P/E Ratio = Market Price per Share / Earnings per Share
The market price per share is how much people are currently paying for one share of the company's stock. Earnings per Share (EPS) tells us how much money the company made per share. We divide the market price by the earnings to get the P/E ratio.
Looking into the Future
We also try to guess how much money a company will make in the future. It's like predicting how much fun a new toy will bring. We consider things like what's happening in the world and how the company is doing to make our guess.
How a Company Performed in the Past
We can also look at how a company did in the past to understand its value. It's like checking if a toy has brought joy to many kids before you decide to buy it. We compare the market price to how much the company made in the last twelve months (TTM) to get an idea.
Formula:
Trailing P/E Ratio = Market Price per Share / Earnings per Share (TTM)
Why P/E Ratios Can Be Different
Companies can have different P/E ratios for various reasons:
- Companies in different industries may have different growth prospects and levels of success. Just like some toys are more popular and fun than others, some industries have better expectations for growth, which can affect the P/E ratio.
- Each company is unique, just like you and your friends. Some companies are better at making money or have a special position in the market. These things can change their P/E ratios.
- How people feel about a company or industry can also affect the P/E ratio. Sometimes, people get excited about a new toy or game, and the same happens with companies!
What the Price Tells Us about the Future
We can use the P/E ratio to understand what people expect from a company in the future. It's like guessing how fun a toy will be based on its price. If the forward P/E ratio is high, it means people believe the company will make more money and be even more exciting!
Formula:
Forward P/E Ratio = Market Price per Share / Forward Earnings per Share
Challenges with P/E Ratios
Picking the Right Comparisons
When comparing P/E ratios, we need to choose companies that are similar, just like comparing toys of the same type. Comparing companies from different industries can give us wrong information.
Looking at the Bigger Picture
<p>To understand an entire industry, we need to look at many companies together. It's like seeing what toys are popular among your friends and their friends. We need to combine the P/E ratios of different companies in a fair way.</p>
The Earnings Problem
P/E ratios can be tricky when a company is not making much money or even losing money. It's like trying to figure out the price-to-fun ratio of a toy that is not fun or too expensive. In those cases, we can use other ways to decide if it's a good buy, just like looking at the toy's popularity or its price compared to how many it has sold.
Understanding the Past Year
We adjust the earnings of the past twelve months to get a better idea of how well a company did. It's like looking at a toy's performance over the past year. We make these adjustments when important things like buying or selling other companies happen.
These are the main things you need to know about Price-Earnings Ratio (P/E) and how it helps us understand the value of a company. Just like you compare toys before buying, we compare companies to make smart decisions!
This article takes inspiration from a lesson found in FINN 3103 at the University of Arkansas.