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What is price earnings ratio? Meaning and Significance

Updated on April 19, 2013
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What is Price Earnings Ratio?

Price Earnings Ratio, is a simple common financial formula used by value and conservative investors. Benjamin Graham and Warren Buffett, famous investors and analysts, were strong proponents of this technical term. Price Earnings Ratio, helps to find whether the current stock, sector or market is overvalued or undervalued.

This formula for Price Earnings ratio is simply the current price of the stock divided by annual earnings of the company. It is always good to compare two stocks in the same industry. For instance, AGNC, mortgage REIT, stock price is $32.16. Annual earnings per share is $6.40. Thus, price earnings ratio is 32.16/6.40= 5.02. Another stock in the same industry is IVR. Stock price is $18.85 and annual earnings per share is $3.15. Thus, price earnings ratio is 18.85/3.15 = 5.99. Hence, even though the stock price of AGNC is high as compared to IVR, it is relatively cheaper when earnings per share is taken into consideration.

Meaning and Significance. Price Earnings Ratio is dependent on time of investing. Certain periods, this ratio tends to be low and other times, it can go up. Just before the burst of bubble of dot com companies, price earnings ratio was astronomically high. Hence, it is a good financial indicator of the market conditions and act as good predictor of the dangers ahead. It is always good to understand these simple financial terms as it can help us to save our savings or even retirement income from a sudden collapse in market.

In general, price earning ratio of 0-5 is low whereas above 20 is high. Moderate price earning ratio is somewhere between 5-20. However, the PE ratio depends on the time of investing, sector and industry. The average ratio might be completely different for one industry like mortgage REITs as compared to technology stocks.

Conservative investors tend to focus on stocks with low price earnings ratio. However, low price earnings ratio can also indicate that investors have less confidence in this stock and the growth prospects of the stocks are low.

Full time investors who are looking for significant growth and high returns, tend to find stocks with high price earnings ratio as good candidates. High PE ratio indicates that market is willing to pay higher price for small earnings of this company. This implies that future confidence in earnings is high. Companies like AAPL, technology stock, can have very high price earnings ratio during the growth period. So, sometimes there is a hidden goldmine in companies with high PE ratios too.

In Summary, there is no right or optimum price earning ratio. It is a financial term which provides us some clues and helps us in analysis. It is commonly used by analysts and value investors to compare stocks and sectors. It is good to understand financial ratios as it helps us to take a good decision. Investment involves risk and it is important to have proper guidance before starting on this journey.

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    • Ruchi Urvashi profile image
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      Ruchi Urvashi 5 years ago from Singapore

      Thanks Jason. Yes, investing with sound financial education is good.

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      jasontoheal 5 years ago

      Good to have this explanation. There are a lot of people who hear lingo and just carry on without knowing what on earth was just said.