Question

P/E ratio is used regularly as a valuation metric and you will often hear it discussed in the business news media (i.e. CNBC, Bloomberg, Fox Business, etc.), what do you think about the use of P/E?

Easy? Good idea? Would you rely on it for your valuation purposes? Any other thoughts?

Answer 1

P/E ratio means the company's stock price to the company's earning per share

P/E ratio = Market price per share / Earnings per share.

Market price per share is the price of each share in the open market or how much it would cost to buy a share and earnings per share is the total earnings of the company during the year.

Let us discuss how a rational investor will think:

Any investor before investing will check two things one is risk and the other is return. Even though return is the main criteria. Earings to price ratio is the key financial items that shows how much return an investment is making. Even though the investor may or may not get the return into his pocket but this determines how much profit his money is making, moreover a company which has more retention ratio has better growth if it able to utlise the said profits by making better investments.

If were observe any in any media or business new paper the main thing we compare between companies in a similar industry is through its valuation mentiuoned as the number of times the P/E ratio. Like some times they say that it is 20 times or so. The number of times of P/E ratio the stock is trading also takes into consideration other factors like corporate governance, Experience and background of the company etc.

Hence Simply speaking P/E ratio is the best measure to value a company.

Other thoughts we can also consider but not so reliable for valuation purpose can be -

a) Return on Capital Employed

b) Return on net assets

c) Book Value per Share

d) Dividend Policies etc