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.Join us on Facebook for more exciting updates and discussion about value investing. Submit your email address for important market updates and FREE case studies![contact-form-7 404 "Not Found"] We will only provide you with information relevant to value investing. You can unsubscribe at any time. Your contact details will be safeguarded. The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Stanley Lim’s personal capacity and do not in any way represent those of his employer and other related entities. Stanley Lim do not own any shares from the above article.