Price-to-Earnings (P/E): What is the price relative to earnings?
What you will learn
Calculate the P/E for price 60 and earnings per share 3, and explain what we still do not know about the company.
The price-to-earnings (P/E) ratio is the share price divided by earnings per share. It is a ratio, not a forecast and not a buy recommendation.
Earnings per share is the profit attributable to ordinary shareholders divided by the relevant number of shares; reports may use a weighted average and also consider dilution. A historical P/E uses past earnings; a forward P/E uses an estimate that may change. When earnings are zero, you cannot divide by them. When the company is losing money, a negative P/E is not a standard measure of being “cheap.” Comparisons require similar companies, a consistent calculation method, debt, growth rate and earnings quality. One-off earnings can distort the ratio.
In a fictional company, the share price is 100 ₪ and the earnings per share in the year are 5 ₪: the P/E is 100 ÷ 5 = 20. If the price stays 100 and earnings fall to 2, the P/E rises to 50. This does not guarantee a return of the investment in 20 years.
Calculate the P/E for price 60 and earnings per share 3, and explain what we still do not know about the company.
An imaginary share trades at 60 money units and annual earnings per share are 3. Dividing 60 by 3 gives a price to earnings ratio of 20. If earnings rise to 6 while the price stays 60, the ratio falls to 10 without a price decline. Check whether earnings are reported or forecast and whether unusual events affected them. A low ratio alone does not prove value. Losses may make the usual ratio unsuitable.
Concepts that help you compare
Stock: a small piece of a company
A stock is a share of ownership in a company. A stock’s price changes in the market and is not a promise of future value. A company may distribute part of its profits as a dividend, but it is not required to do so. You can gain from a price increase or lose from a price drop; in an extreme case you can lose your entire investment.
Comparison example: If you bought two shares at 50 ₪ each, the cost is 100 ₪ before fees.
Issuing and trading shares: who receives the money?
Issuing new shares can raise money for a company. In trading between investors, the seller usually receives the money. Tradable shares allow investors to buy and sell on the market. Public companies have reporting obligations, but reporting and oversight do not guarantee success. A private company is not necessarily small, and a public company is not necessarily government-owned. Trading between investors is not always new money entering the company.
Comparison example: Buying from another investor on the stock exchange usually transfers the proceeds to the seller. Issuing new shares by the company can raise money for the company.