Price-earnings ratio (P/E ratio)

What is the price-earnings ratio?

The price-earnings ratio (P/E ratio) is a measure of the price paid for a share relative to the annual income or profit earned by the company. It is calculated by dividing the share price by the earnings per share (EPS). The higher the P/E ratio, the more expensive the share price is relative to the earnings of the company.

How is the price-earnings ratio calculated?

The price-earnings ratio is calculated by dividing the share price by the earnings per share (EPS).

What does the price-earnings ratio tell us?

The P/E ratio tells us how much investors are willing to pay for each dollar of a company's earnings. A high P/E ratio means that investors are willing to pay a higher price for each dollar of earnings, while a low P/E ratio means that investors are willing to pay a lower price for each dollar of earnings.

How can the price-earnings ratio be used?

The P/E ratio can be used to compare the relative value of shares of different companies. It can also be used to compare the relative value of shares of the same company at different times.

What are the limitations of the price-earnings ratio?

The P/E ratio has a number of limitations. First, it only tells us how much investors are willing to pay for each dollar of earnings. It does not tell us whether the shares are actually under- or over-valued. Second, the P/E ratio does not take into account the company's growth prospects. A company with high growth prospects may have a high P/E ratio even if its shares are under-valued. Third, the P/E ratio is affected by accounting choices. For example, a company can choose to report higher EPS by including one-time items such as asset sales. Finally, the P/E ratio does not tell us anything about the company's dividend policy or its financial health.

How do I interpret a high or low price-earnings ratio?

A high P/E ratio means that investors are willing to pay a higher price for each dollar of earnings. This may be because the company has high growth prospects, or because the shares are under-valued. A low P/E ratio means that investors are willing to pay a lower price for each dollar of earnings. This may be because the company has low growth prospects, or because the shares are over-valued.

What are some common mistakes investors make with the price-earnings ratio?

Some common mistakes investors make with the P/E ratio include using it to compare companies in different industries, using it to compare companies at different stages of their life cycles, and using it to compare companies with different dividend policies. Another mistake is to blindly buy shares with a high P/E ratio in the hope that they will go up in value. This is known as the greater fool theory, and it rarely works out well in practice.

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