What Is A P/E Ratio?

The Motley FoolA P/E ratio is simply one way of valuing a company. Let’s say a company, which is worth $500m, made a profit of $100m last year. The company is therefore said to be valued at five times profits. Put another way, it is said to have a Price to Earnings or P/E of 5.

Let’s assume that this company has 100 million shares in circulation. So the price of each share is $5 and the earnings per share (eps) are $1. The price to earnings or P/E is simply the share price divided by the earnings per share. In other words, five divided by one, which is five.

A P/E of five means that if the company could deliver a steady profit of $100m every year, then theoretically an investor would get his money back after five years. So the P/E is a quick way of working out how long it would take to recoup an investment.

What’s interesting is when the company is able to grow its profits steadily every year. Let’s say it made $100m this year, $110m next year, $120m the year after, $130m the year after and $140m the year after that. This means that you could recoup your $500m investment in just over four years.

This could make the company more desirable than one whose profits were constant. So, you might be prepared to pay slightly more for the faster-growing business. Perhaps you might pay six times current profits because now you expect to recoup your $600m investment in five years.

So a P/E ratio can be seen as an indication of the expected future growth of the business. Companies that are expected to grow faster should therefore have higher P/E values. Conversely, those with slower growth should have lower P/E ratios. That, though, is the theory. However, the stock market can sometimes behave irrationally, which is when rational investors can step in to unearth hidden opportunities.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.