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Understanding the P/E Ratio

P/E is short for the ratio of a company's share price to its per-share earnings. As the name implies, to calculate the P/E, you simply take the current stock price of a company and divide by its earnings per share (EPS).

A valuation ratio of a company's current share price compared to its per-share earnings is calculated as: -

=     Market value per share
Earnings per share

The P/E ratio is the market's assessment of a company's future prospects. Although very simple to calculate, it is one with gargantuan implications.

Components of P/E Ratio

There are two primary components here, the market value (price) of the stock and the earnings of the company. Earnings are very important to consider. Earnings represent profits for what every business strives. Earnings are calculated by taking the hard figures into account: revenue cost of goods sold (COGS), salaries, rent, etc. These are all important to the livelihood of a company. If the company isn't using its resources effectively, it will not have positive earnings, and problems will eventually arise.

Calculation of P/E Ratio

Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E. However, occasionally the EPS figure comes from estimated earnings expected over the next four quarters. This is known as the leading or projected P/E. A third variation that is also sometimes seen uses the EPS of the past two quarters and estimates of the next two quarters.

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* Contributed by: -
Varun Dawar,
PGDBM, Batch 2004-06,
Institute of Management Technology (IMT), Ghaziabad.