Price to Earnings (PE) Ratio

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.

Formula

Price to Earnings Ratio = Current Market Price / Reported Earnings of the Company

Meaning

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.

Assumptions

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:

  • Earnings are Stable: The price to earnings ratio implicitly assumes that the earnings of a given company will remain stable over the period of time that the investment made is being recovered. However, this is seldom the case. Businesses are subject to business cycles and earnings move cyclically. 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.

  • Earnings Have Not Been Manipulated: There is a lot of evidence that the earnings of a company are subject to gross manipulation. The management has an unfair control over what it can project to the investment community as earnings. 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, na´ve 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.

Interpretation

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.

  • Does Not Factor In Growth Rates
  • Does Not Factor In Compounding

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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