Calculating Price/Earnings Ratio (P/E)

A P/E Ratio is the market price of stock to earnings per unit of stock of the company.  For example, a stock selling for $100 a share and earning $10 a share has a P/E ratio of 10. This means the stock you hold earns the company a profit of $10 and that you are willing to wait for ten years to realize the capital you have invested in the stock at the current rate of earnings.  If the P/E ratio to earnings ratio is high, you are paying more for a stock that is earning very little.  If the P/E ratio is low, it means your stock is earning more income and is a good stock to hold. In other words, the ratio is the most common measure of how expensive a stock is.  It  gives investors a rough idea of how much they are paying for earning power.  P/E ratio is also known as earnings multiple.

P/E multiple or multiple should be calculated on earnings after setting off any provisions made. Calculating price-earning ratios (P/E ratio) can be an important part of determining risk in growth stocks, but the ratios should not be examined alone.  A current P/F ratio in comparison to a company’s twelve year average P/E ratio can show whether a stock is currently more or less attractive to buyers.  Although it is an oversimplification, a higher than average P/F is considered to indicate more risk, and a lower than average P/E means less risk.  The P/E ratio is dependent on financial parameters, financial ratios and performance factors as compare to the earnings of company which should be given on the basis of after tax earnings. It should not be inflated on before tax provision calculations for enabling correct indicators for prices to been multiples of earnings. 

Methods used for Calculating price/earnings (P/E) ratio vary. To cite a few examples:

• Trailing P/E ratio
• Forward P/E ratio
  

Trailing P/E ratio  is the one most often cited in newspapers and in stock tables as well as bulletins.  Trailing P/E ratio is calculated by dividing the price of the stock by the earnings per share and that has been made over the past twelve months. 

P/E variation is called as forward P/E.  Forward P/E is calculated by dividing the price of the stock by the estimation for the earnings per share for the future years.  This estimation is used and made by the Wall Street and is reflected in Wall Street journals.

The advantages of Trailing P/E ratio over the forward P/E ratio is that in the denominator of the formula by which it is calculated which contains the audited earnings number.  This has been reported to the Securities and Exchange Commission.  Though these numbers are not stable, that means that in the near future a change in negative or positive direction will be experienced.

Forward P/E ratio includes considerations about the growth expectations through the use of future earnings in the calculations.  The projected estimation may not coincide with the ones that are actually reported at the end of the year, forward P/E ratio gives a general view on the future performance of the stock.

When you are comparing the performance of two companies, assuming that they offer the same future financial parameters, the calculation of the forward P/E ratio of the companies may highlight the nuances of business parameters in both the companies which will have a bearing on their stock performances.

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