Price to Earnings Ratio (P/E)

P/E or Price to Earnings Ratio is the ratio of a stock’s price to its earnings per share (EPS). This is a popular metric for valuation of stocks. It is used for assessing whether a stock is cheap or richly valued at its current market price. EPS is the earnings of a company which can be distributed to shareholders as dividends or re-invested in the business for future growth.

How is P/E Ratio calculated?

P/E is calculated using the market price and earnings:

P/E or P/E Ratio = Market Price per share/Earnings Per Share

If earnings are expected to grow in future, the share price goes up and vice versa. If the share price moves much faster than the earnings growth, then PE ratio becomes high. If the share price falls faster than earnings, the PE ratio becomes low. A stock with high PE ratio is considered to be expensive while that with low PE ratio is considered to be cheap.

What are the limitations of P/E ratio?

​​P/E has some limitations like:
1. P/E takes into account only the earnings and market price, but not the company’s debt and this can give skewed results
2. Earnings can fluctuate and hence cannot be assumed to be constant
3. P/E doesn’t consider cash generation capability of a business
4. A company with lower PE is considered as ‘cheap’, but it does not give information regarding its quality of earnings and thus the investment might not necessarily be good