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PE Ration Definition & Importance

The price-to-earnings ratio, or P/E ratio, is an equity valuation multiple. It is defined as market price  per share divided by annual earning per share.

>"Trailing P/E" uses net income for the most recent 12 month period, divided by the weighted average number of common shares in issue during the period. This is the most common meaning of "P/E" if no other qualifier is specified. Monthly earnings data for individual companies are not available, and in any case usually fluctuate seasonally, so the previous four quarterly earnings reports are used and earning per share are updated quarterly. Note, each company chooses its own financial year so the timing of updates varies from one to another.

• "Trailing P/E from continued operations" uses operating earning , which exclude earnings from discontinued operations, extraordinary items (e.g. one-off windfalls and write-downs), and accounting changes.
• "Forward P/E": Instead of net income , this uses estimated net earnings over next 12 months. Estimates are typically derived as the mean of those published by a select group of analysts (selection criteria are rarely cited).

Some people mistakenly use the formula market capitalization/net income to calculate the P/E ratio. This formula often gives the same answer as market price /earning per share , but if new capital has been issued it gives the wrong answer, as market capitalization  =  market price × current number of shares whereas earning per share = net income  /weighted average number of shares.

Variations on the standard trailing and forward P/E ratios are common. Generally, alternative P/E measures substitute different measures of earnings, such as rolling averages over longer periods of time (to attempt to "smooth" volatile or cyclical earnings, for example),^[3] or "corrected" earnings figures that exclude certain extraordinary events or one-off gains or losses. The definitions may not be standardized. For companies that are loss-making, or whose earnings are expected to change dramatically, a "primary" P/E can be used instead, based on the earnings projections made for the next years to which a discount calculation is applied.

Interpretation

By comparing price and earnings per share for a company, one can analyze the market's stock valuation  of a company and its shares relative to the income the company is actually generating. Stocks with higher (or more certain) forecast earning growth have a higher P/E, and those expected to have lower (or riskier) earnings growth usually have a lower P/E. 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 (especially the earning growth rate ), it is a less attractive investment.Companies are rarely equal, however, and comparisons between industries, companies, and time periods may be misleading. P/E ratio in general is useful for comparing valuation of peer companies in similar sector or group.

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