Ratios: Price-Earnings Ratio (PE Ratio) - Online Tutor, Practice Problems & Exam Prep

The Price Earnings (PE) ratio is calculated as the market price per share divided by earnings per share (EPS). EPS is determined by net income minus preferred dividends, divided by the average number of common shares outstanding. A lower PE ratio indicates better value for investors, while a higher ratio may suggest anticipated future earnings. Understanding this ratio helps investors assess stock value and make informed decisions in the context of financial accounting and investment strategies.

Ratios: Price-Earnings Ratio (PE Ratio)

Alright. So let's discuss the price-earnings ratio, usually called the PE ratio. Well, that's how we're going to calculate it. It's going to be the price over the earnings. Okay? The PE ratio is a common market value ratio. We deal with the actual market value of the stock. Investors use this when they're thinking about investing in a stock. Well, how much earnings are they going to get per dollar that they invest here? Okay.

An important part of this ratio is the earnings per share. Often when we deal with the price-earnings ratio, they're really just asking you to calculate earnings per share and then do price divided by earnings per share. The trickiest part of this could be remembering how to calculate earnings per share. Alright? You might want to go back to the earnings per share video if you need more information, but let's review it real quick right here. Our earnings per share, remember, it's going to be net income minus preferred dividends in our numerator, and a lot of times they might not talk about preferred dividends. If they don't mention it, consider it to be 0. So, net income minus preferred dividends and in the denominator, we've got the average number of shares of common stock outstanding. Alright?

That's a lot of words, but remember, we're talking about a number of shares. So, we're not talking about like the dollar value of the shares. The book value of equity or something like that. We're talking about a number of shares, 1,000,000 shares outstanding, 500,000 shares outstanding, whatever it is. And we're focused on the common stock, okay? So there could be common shares and preferred shares. We're focused on the common shares that are outstanding. And lastly, it's an average. So, like we've done with averages before, remember, it's going to be the beginning balance plus the ending balance divided by 2. Oright?

So that's usually the most complicated part of this formula because once we get to the price-earnings ratio down below, notice the numerator is the price, right? Price divided by earnings. So the numerator is the current market price of a share of common stock. Okay? They're going to tell you in the problem though, usually say the market price is $20 for a share of stock. Whatever it is. Okay? And the denominator is that earnings per share. So market or price divided by earnings. Alright?

So how do we use this information? What does this really tell us? It tells us the market price for a dollar of earnings, right? Remember, it's how much of the numerator for each one of the denominator. So if there was $1 of earnings, how much would you have to pay for that in market price? Okay. For each dollar of earnings. Cool?

So what's the comparison here? Well, you can imagine that investors want to pay as little as possible for as much earnings as they can, right? So they want a price-earnings ratio that's lower. The lower the ratio, the more value they're getting for each dollar of earnings. So they want to pay as little as possible for those earnings. However, if you see a high price-earnings ratio, sometimes it reaches as high as 20 times or something like that. You can see really high price-earnings ratios. Well, this indicates projections of future earnings, right? Because investors, remember, they're taking into account when the market sets the price with all the demand and supply of the stock. Well, it takes into account all the information that's available. So if investors realize that there's going to be a lot of future earnings, well that's going to bump up the price, right? So that price-earnings ratio, even though there's currently not as much earnings, could project that there's going to be a lot of future earnings. Cool? Alright.

Remember, the main trick here is remembering how to calculate your earnings per share, and then the price-earnings ratio. Well, it's just price divided by earnings. Cool? Alright. Let's jump into some practice problems for the price-earnings ratio.

MoneyCo had sales revenue and net income during the current year of $500,000 and $60,000, respectively. The total amount of stockholders' equity was $600,000, and common shares outstanding were 120,000 all year. If the market price of the stock is $10, what is the P/E ratio?

• A. 5
• B. 10
• C. 20
• D. 40

Tougher Company's current year income statement showed an EPS of $1.25 per share. If total common equity totaled $600,000 (40,000 common shares), preferred dividends were $10,000 (10,000 preferred shares), and the market price of common and preferred stock are $25 and $50, respectively, what is the company's P/E ratio?

• A. 5
• B. 10
• C. 20
• D. 40

Here’s what students ask on this topic:

What is the Price-Earnings (PE) ratio and how is it calculated?

The Price-Earnings (PE) ratio is a financial metric used to evaluate the value of a company's stock. It is calculated by dividing the market price per share by the earnings per share (EPS). The formula is:

$\frac{\mathrm{Market\; Price\; per\; Share}}{\mathrm{Earnings\; per\; Share\; (EPS)}}$

EPS is determined by subtracting preferred dividends from net income and then dividing by the average number of common shares outstanding. A lower PE ratio indicates better value for investors, while a higher ratio may suggest anticipated future earnings.

Why is the PE ratio important for investors?

The PE ratio is important for investors because it helps them assess the value of a stock. A lower PE ratio suggests that the stock is undervalued, providing more earnings per dollar invested. Conversely, a higher PE ratio may indicate that the stock is overvalued or that investors expect high future earnings growth. By comparing PE ratios across companies or industries, investors can make more informed decisions about where to allocate their funds.

How do you calculate Earnings Per Share (EPS) for the PE ratio?

To calculate Earnings Per Share (EPS), use the following formula:

$\frac{\mathrm{Net\; Income\; -\; Preferred\; Dividends}}{\mathrm{Average\; Number\; of\; Common\; Shares\; Outstanding}}$

First, subtract any preferred dividends from the net income. Then, divide this result by the average number of common shares outstanding, which is calculated by adding the beginning and ending number of shares and dividing by two. This EPS value is then used in the PE ratio calculation.

What does a high PE ratio indicate about a company's stock?

A high PE ratio indicates that investors are willing to pay a higher price for each dollar of earnings, often due to expectations of future growth. It suggests that the market anticipates significant future earnings increases. However, it can also mean that the stock is overvalued. Investors should consider other factors and metrics alongside the PE ratio to make well-rounded investment decisions.

How does the PE ratio help in comparing different companies?

The PE ratio helps in comparing different companies by providing a standardized measure of stock value relative to earnings. By comparing the PE ratios of companies within the same industry, investors can identify which stocks are potentially undervalued or overvalued. This comparison aids in making more informed investment choices, as it highlights how much investors are willing to pay for a dollar of earnings across different companies.