14.4 Price/earnings ratio

Question 1

What does the price/earnings ratio measure? How is it calculated?

Answer 1

It measures the current market price of the shares relative to earnings per share (EPS). i.e:

P/E Ratio = [Market price per share] / [EPS]

Question 2

How is the industry average price/earnings ratio used to measure the value of a company’s shares?

Answer 2

Value of share = EPS x industry P/E ratio

Question 3

Is is better to have a higher or lower price per earnings ratio?

Answer 3

It varies:

• high PE ratio could indicate the possibility for high future earnings, or that the share is being overvalued
• low PE ratio could indicate undervalued shares, which makes for a good investment

Question 4

What are the limitations of the PE ratio?

Answer 4

• company can artificially inflate earnings to improve the ratio
• ignores important variables such as dividends,risk etc
• PE ratio only looks backwards, and does not reflect matters such as changing market conditions
• does not consider debt (only earnings)