Question

What does a P/E Ratio indicate?

Explain how you would feel about seeing a P/E ratio of 188 for a company

Explain how you would feel seeing a P/E ratio of 9 for a company

Be sure to cover all three questions in your answer

Answer 1

P/E ratio is a measure of the share price, relative to the earnings of the company.

P/E ratio = current market price of stock / earnings per share

Earnings per share is usually abbreviated as EPS.

Thus, the P/E ratio indicates the number of times EPS at which the market has priced the stock. For example, for a stock with a P/E ratio of 20, the market price of each share is 20 times its EPS.

If I see a P/E ratio of 188, I would feel the stock is overvalued. This is because the price of the stock is 188 times its yearly earnings. If the stock's earnings remained the same, and the company paid out all its earnings as dividends, it would take me 188 years to recover my investment!

If I see a P/E ratio of 9, I would feel the stock is not overvalued. This is because the price of the stock is only 9 times its yearly earnings. However, I would still need to compare this P/E ratio with other firms in the industry, to really conclude whether the stock is undervalued or fairly valued. P/E ratio differs in each industry, and depends on industry dynamics, microeconomic structure, sector etc. Thus, a share with P/E ratio of 9 could be fairly valued if it is in an industry where this is close to the industry average P/E ratio.