Price to Earnings Ratio or P/E Ratio is a matrix to compare the attractiveness of the price of a stock with each other. The formula for the matrix is
P/E = Price of Share / Earnings Per Share
Earnings per Share = Net Income / Number of Shares Outstanding
A company trading at $10.00 per share and has an earnings per share of $1.00 per share is said to be trading at a P/E ratio of 10 times. Typically, a company with a low P/E ratio is described as cheap while one with a high P/E ratio is described as expensive.
The limitation of P/E ratio is when a company is having a temporary bad year; it might end up with very low earnings per share for that year, which will cause a high P/E ratio for the company. Secondly, companies that have large fair value gains or non recurring incomes will skew its earning per share upwards. This will cause the appearance of a very low P/E ratio which is quite misleading. P/E is just one method of valuing a company and investors should not base their investment decision solely on just one matrix.
Other examples of valuation methods includes Price to Book Ratio, Price to Cash Flow Ratio, Enterprise Value to EBITDA Ratio, Discounted Cash Flow method, etc. Stay tune for more on valuation matrix.
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