Bears in the Bond Market
If certain high profile fund managers and bond investors are to be believed, then the bond market has just slipped into a bear market. They are not talking about the usual tightening of the Fed’s interest rates. Interest rates have risen several times over the past few years. However, every time they return to normal. […]
Bretton Woods Agreement and Smithsonian Agreement
The transition of the world monetary system from gold standard to the modern Forex markets was anything but smooth. Governments from all over the world collaborated to make two pacts which would form the basis of the modern monetary system. However, both the arrangements failed. In this article, we will have a closer look at […]
The Economic Impact of Facebook Outage
Facebook is one of the largest social media firms in the world. The Facebook family of apps, i.e. Facebook, WhatsApp, Instagram, and Messenger are used by over a billion people from all across the world. Most of these services have been in operation for over a decade. All these services seem to function seamlessly almost […]
Check Printing and Mailing Services offered by Commercial Banks
Corporations all across the world make a wide variety of payments via checks. This includes statutory payments, payments to utility vendors as well as many other vendors who do not have access to electronically enabled payment systems. These checks are automatically issued using a digital signature. The process of creating and issuing these checks is […]
The Decline of the Big Corporation
The era of big corporations started during the industrial revolution. The past couple of centuries have witnessed the rise of these mega-corporations, particularly in the developed western world. In many cases, these corporations have become extremely powerful and have behaved aggressively with weaker nation-states as well. The idea that some private individuals can amass more […]
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.
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