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Price-to-Earnings Ratio Method of Business Valuation

Original post by David Carnes of Demand Media

Financial analysts use many different metrics to determine the real value of a company and its shares. One of the most popular metrics, the price-to-earnings ratios, or P/E ratio, is based on share price and company earnings. The P/E is only useful to value publicly traded companies, and should be considered in conjunction with other business valuation metrics.

The P/E Ratio

The P/E ratio is simply the share price divided by the company's earnings per share. "Earnings per share" represents the company's total annual earnings divided by the number of issued and outstanding, publicly available shares. For example, if a company earns \$10 million in a given year and has issued 5 million shares to the public, its earnings per share is \$2. If its share price is \$50 per share, its P/E ratio is 25.

Interpretation

In general, the higher a company's earnings, the greater the real value of its shares. The P/E ratio is a way of comparing the share price with an estimate of its real value and, by extension, a way of determining whether the entire company is overvalued or undervalued by investors. The lower a company's P/E ratio, the more of a bargain an investment in its shares is likely to be. Nevertheless, a high P/E ratio is not necessarily bad -- it might indicate that investors are legitimately anticipating high future growth.

Uses

The P/E ratio can be used to compare the value of shares of different companies to determine which one to invest in. Analysts also compare the P/E ratios of the same company over several years to determine long-term trends. The P/E ratio can be interpreted as an expression of how many years of earnings would be required to recoup the share price--if the P/E ratio is 25, for example, it would take 25 years for investors to recoup the share purchase price if the company distributed all of its earnings as dividends (ignoring inflation and assuming constant earnings).

Misuse

Experienced investors take care when comparing the P/E ratios of companies in different industries. The P/E ratio of shares of a technology company. for example, might not be overpriced at 30 or even higher, while a P/E ratio of 30 might be considered extremely high in another industry. Furthermore, determining a company's P/E ratio is not an adequate substitute for taking a more specific look at a company's finances, capital structure and market position.

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