Current Ratio – Formula, Meaning, Assumptions and Interpretations
February 12, 2025
Trading foreign exchange is markedly different from trading other financial assets in the market. There are certain unique features of foreign exchange which make it so different. In this article we have listed down these features and explain how they influence an individual’s ability to trade the market. Currencies Come in Pairs The biggest difference […]
The fixed-income security market is mostly composed of financial instruments which offer a fixed stream of income to investors. In other words, this means that the possible downside that investors may face is protected while at the same time investors can have only a limited upside. This is exactly opposed to stocks wherein the possible […]
Dhirubhai Ambani was the perfect rags to riches story that India had ever seen. He had started out with nothing. However, he ended up becoming the richest man India has ever seen. During his meteoric rise, Dhirubhai Ambani, owner of the Reliance group of companies, beat some of the richest and most politically well-connected men […]
What is Financial Modelling and how it is extremely critical for High Finance In the world of banking and high finance, modelling or financial modelling is a term used to describe the process of forecasting and estimating risk and return as well as predict how the future would be in financial aspects. Financial Modelling is […]
We have earlier discussed the fact that Net present Value (NPV) is considered to be the gold standard when it comes to financial decision making. If a project has an NPV greater than zero then it is supposed to be a financially viable project and the firm must invest its resources towards that project, if […]
The price to earnings ratio is the most fundamental of all market related ratios. It has been used for decades by stalwarts in the investment community. However, it is also the ratio that has come under maximum fire from the skeptics. A variety of measurements have been developed to compensate for what skeptics call the lack of correct information provided by the price earnings ratio. Almost all other market related ratios are a variation of the price to earnings ratio.
Price to Earnings Ratio = Current Market Price / Reported Earnings of the Company
The price to earnings ratio tells the investors how many rupees they are paying for every rupee in earnings that the company presently has. If the price to earnings ratio is 5, then investors are paying 5 rupees to get a stream of earnings of 1 rupee per year till perpetuity. This ratio therefore also implicitly tells the payback period which in this case would be 5 years.
There are a lot of assumptions that the price to earnings ratio implicitly makes. This is the reason that this ratio has come under a lot of criticisms from skeptics who think that price to earnings ratio provides a distorted image of what the reality of the company really is. The common assumptions are as follows:
The world is yet to see a company that has been able to generate stable earnings for an extended period of time. This is why the price earnings ratio may present reality to be different than what it really is.
Moreover the investment community may not enough data at hand to adjust these earnings and arrive at a figure which they think are fair earnings of the company. Hence, naive investors who only look at price-earnings ratios without looking at whether the earnings have been manipulated will possibly make wrong decisions based on this number.
The price to earnings ratio must be interpreted in the light of the fundamentals of finance. These fundamentals are the fact that an investment grows over a period of time. This growth pattern usually follows an exponential pattern which makes the phenomenon of compounding so important.
The fact that price to earnings ratio uses simple arithmetic division makes it unacceptable to many skeptics in the investment community.
Your email address will not be published. Required fields are marked *