P/E ratio of currencies
Before I go into how to calculate the P/E of currencies, let me first define what the (traditional) definition of the P/E ratio is.
P/E ratio is used to calculate the fair value of a share. It is probably the most widely used ratio for shares, and usually used by comparing the P/E result of a specific company's share to the average P/E ratio of all the major companies within an industry. Obviously if the P/E of the observed company is lower than that of the industry average, it is undervalues, if it is higher than the industry average, it is overvalued.
This is how the P/E ratio is calculated.
P stands for Price, which is simply the price of the share. Of course Price can be used for share options, and futures, but for sake of simplicity lets stay with the current, spot share price.
E stands for Earnings, which is the earnings, e.i., the profit of the company.
Simply divide the price of one share with the profit per one share, and you get the result.
Now that we have the basics out of the way, let us discuss how P/E could be used to evaluate currencies of the forex market.
First what is the price of a currency. It is simply the spot exchange rate of a currency (of course there are fx options and fx futures, but the principle is the same as the with spot forex). For example, the price of EUR/USD is, say 1.30.
Earnings for currencies are a bit trickier. For share it is the profit, which is a percentage earning on a share. It is different from dividends, because earnings include dividends PLUS unpaid (retained) profits. In that sense, for a currency the percentage earning (yield) is simply the central bank interes yield. If the European Central Bank (ECB) is 0.2, and the Federal Reserve Bank (US Fed) is 0.25, dividing the two, we get 0.8, if we open a long position. If we open a short position, we divide FED rate with ECB rate.
To get the P/E for the EUR/USD currency pair, in our above examples we get the following equation.
P/E= 1.3/0.8=1.625
Why would you calculate the P/E of a currency. It is mostly useful for swing or carry traders (they hold on a position for more that a day, e.i, they are not daytraders).
