Price/Earnings (P/E) Ratio

Price/Earnings or P/E ratio is the ratio of a company's share price to its earnings per share. It tells whether the share price of a company is fairly valued, undervalued or overvalued.

Formula

P/E Ratio = Current Share Price
Earnings per Share

Current share price is obtained from secondary markets like NYSE, NASDAQ, etc. while EPS is calculated as (net income minus preferred dividends)/weighted average number of shares outstanding.

Leading and Trailing P/E Ratio

If the EPS is the figure for the current period the P/E ratio is called trailing P/E ratio. For better analysis the EPS should be the one expected to prevail in the next reporting period, say next year. P/E ratio calculated based on expected P/E ratio is called leading P/E and is a more meaningful estimate of the company's justified P/E ratio.

Analysis

For financial analysis justified P/E ratio is calculated using dividend discount method.

P/E Ratio = Expected Payout Ratio
Required Rate of Return − Dividend Growth Rate

If the justified P/E calculated using dividend discount analysis is higher than the current P/E ratio the share is undervalued and should be purchased. If the justified P/E is lower than P/E ratio the share is overvalued and should be sold.

Example

A share of T Ltd. has current market price of $20 and it's EPS for current period is reported as $2. It's EPS for next period is expected as $2.5, expected payout ratio is 40%, required rate of return is 12% and growth rate is 6%. Find the trailing P/E, leading P/E and justified P/E.

Solution

Trailing P/E = current share price/current year EPS = $20/$2 = 10
Leading P/E = current share price/next year EPS = $20/$2.5 = 8
Justified P/E = payout ratio/(required rate of return − growth rate) = 40%/(12% − 6%) = 40%/6% = 6.67

Reciprocal of P/E ratio is called earnings yield (which is EPS/price).

by Obaidullah Jan, ACA, CFA and last modified on

Join Discussions

XPLAIND.com is a free educational website; of students, by students, and for students. You are welcome to learn a range of topics from accounting, economics, finance and more. We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. Let's connect!

Copyright © 2010-2019 XPLAIND.com