The P/E ratio (Price-to-Earnings ratio) of a stock (also called
its “earnings multiple”, or simply “multiple”) is a measure of the price paid
for a share relative to the income or profit earned by the firm per share. A
higher P/E ratio means that investors are paying more for each unit of income.
It is a valuation ratio included in other financial ratios.

The price per share (numerator) is the market price of a single
share of the stock. The earnings per share (denominator) is the net income of
the company for the most recent 12-month period, divided by number of shares
outstanding.

For example, if Stock A is trading at $30 and the earnings per
share for the most recent 12-month period is $3, then Stock A has a P/E ratio
of 30/3 or 10. Put another way, the purchaser of Stock A

is paying $10 for every dollar of earnings. Companies with losses or no profit have an undefined P/E ratio. However, a negative P/E ratio may be shown.

is paying $10 for every dollar of earnings. Companies with losses or no profit have an undefined P/E ratio. However, a negative P/E ratio may be shown.

By comparing price and earnings per share for a company, one can
analyse the market’s stock valuation of a company and its shares relative to
the income the company is actually generating. Investors can use the P/E ratio
to compare the value of stocks: if one stock has a P/E twice that of another
stock, all things being equal, it is a less attractive investment. Companies
are rarely equal, however, and comparisons between industries, companies and
time periods may be misleading. Hence, more complicated peer group analysis is
required.

Care should be taken when analysing P/E ratios. It is also common
market practice to use historic P/E ratios, or forward P/E ratios which factor
in future consensus corporate growth rates. Either way, how do we interpret in
a simple manner what the ratios means? If a company trades on a P/E ratio of
10, we could conclude that it takes about ten years to recoup the price paid
for a stock (not including any income from the reinvestment of dividends). In
principle, the P/E ratio incorporates the market’s view of future growth
prospects and perceived riskiness of a company’s future earnings.

Various interpretations are possible, but the table below gives
an indicative guide as to their meaning:

The

**dividend yield**is the dividend paid in the last accounting year divided by the current share price. If a stock paid out $5 per share in cash dividends to its shareholders last year, and its price is currently $50, then it has a dividend yield of 10%.
The

**earnings yield**is the reverse/reciprocal of the P/E ratio. The earnings yield is quoted as a percentage, and is useful in comparing a stock, sector, or the market’s valuation relative to bonds. The earnings yield is also the cost to a publicly traded company of raising capital through the issuance of stock.
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