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Prospectus Price-to-Earnings Ratio

Original post by David Carnes of Demand Media

The price-to-earnings ratio is used to predict future share prices.

The price-to-earnings --- or P/E --- ratio is an important financial metric used to determine the real value of a company's shares. Although the P/E ratio is an important measure of a company's financial health, it is only one of many metrics used to evaluate the value of company shares.

Definition

The P/E ratio is calculated by dividing the share price of a company's publicly traded stock by its earnings per share over any 12-month period. Earnings per share is calculated by dividing the company's reported net earnings by the number of publicly traded shares. The P/E is included in the prospectus that a company uses to attract new investors and in company financial statements.

Use

Three main types of P/E ratios are commonly used: trailing, rolling and forward. The trailing P/E ratio is calculated based on data from the past four quarters. The rolling P/E ratio is based on data from the past two quarters and projections for the next two quarters, while the forward P/E ratio is based on projections for the next four quarters. P/E ratios are used to a compare a company's current performance with its past performance or its projected future performance, and to compare the performance of different companies within the same industry or market. A high P/E ratio suggests that investors expect the company to enjoy high future growth.

Example

Suppose a company's net earnings were $5 million during the 12-month period in question, and that it has 1 million shares of publicly traded stock on the market. In this case, its earnings per share would be $5. If its shares are trading at $60 per share, its P/E ratio would be 60/5 = 12, generally considered a low P/E ratio. A P/E ratio of 12 means that if the company's earnings remained constant and it distributed all of it earnings as dividends, it would take a shareholder 12 years to recoup his investment in his shares, assuming no inflation.

Pitfalls

The main pitfall of analyzing the value of a company's shares using its P/E ratio is failing to consider this metric in context. Average P/E ratios vary by industry. In a high technology industry, for example, a P/E ratio of 28 would not be considered particularly high. It is also important to look at long-term trends, such as the company's P/E ratio over the last 10 years.

                   

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About the Author

David Carnes has been a full-time writer since 1998 and has published two full-length novels. He spends much of his time in various Asian countries and is fluent in Mandarin Chinese. He earned a Juris Doctorate from the University of Kentucky College of Law.

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