Ratios: Price-Earnings Ratio (PE Ratio): Videos & Practice Problems

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)

The Price Earnings Ratio, commonly referred to as the PE ratio, is a key financial metric used by investors to evaluate the market value of a stock relative to its earnings. The formula for calculating the PE ratio is:

PE \, Ratio = \frac{Price}{Earnings \, per \, Share}

In this context, the "price" refers to the current market price of a share of common stock, while "earnings per share" (EPS) is a crucial component derived from the company's net income. To calculate EPS, the formula is:

Earnings \, per \, Share = \frac{Net \, Income - Preferred \, Dividends}{Average \, Number \, of \, Common \, Shares \, Outstanding}

Here, net income is the total profit of the company, and preferred dividends are subtracted only if applicable. The denominator, the average number of common shares outstanding, is calculated by taking the sum of the beginning and ending number of shares and dividing by two:

Average \, Shares = \frac{Beginning \, Shares + Ending \, Shares}{2}

Understanding the PE ratio is essential for investors as it indicates how much they are willing to pay for each dollar of earnings. A lower PE ratio suggests that investors are getting more value for their investment, as they pay less for each dollar of earnings. Conversely, a higher PE ratio may indicate that investors expect significant future earnings growth, which can drive up the stock price despite current earnings being lower.

In summary, the PE ratio serves as a valuable tool for assessing stock value, with the primary focus on calculating earnings per share accurately to derive meaningful insights into investment potential.

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

Answer: (C)

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

Answer: (C)

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.