Price Earnings Ratio

Are you paying too high a price for those earnings?

The price earnings ratio is one traditionally applied to businesses quoted on a stock exchange, where there is a readily available price quoted every day by the market makers.

As part of the rules for being listed on the exchange, each business is obliged to produce a computation of per share earnings, which is the net profits of the business (before distributions to shareholders) divided by the weighted average of shares in circulation for the reported period. Each set of published accounts will contain these figures, and the computation of per share earnings.

There is no reason why you can't compute this ratio in respect of a private company, especially if you're thinking of buying or selling it, to give you an idea of what the value premium above earnings is. There are some factors to take into account such as the effect of a ready market has on share liquidity, and therefore price, and also credit risk, which will inevitably be different for a smaller business (though not necessarily higher).

Price to Earnings Ratio Formula

Share Price / Earnings = Price Earnings Ratio

If you look at this income statement template also shown below, you will see that the computed earnings per share is $4.30

To compute the price earning ratio, you also need to know the share price. Let's say the price was $45 this time last week, and $75 this week. Crazy, but true. In the first case, the earnings ratio would be:

$45 / $4.3 = 10.5 times

and then:

$75 / $4.3 = 17.4 times

This then, is one of the problems with price earnings ratios. The market can be quite fickle, almost manic depressive in nature. It is very likely that the underlying business fundamentals are exactly the same in each of the time periods, but the price quoted varies wildly.

That's where a good dose of common sense comes into play, and the sense checking against historicals for this company would be useful.

It's also worth noting that one of the problems with price earnings computations is that the published earnings data is also historic, and therefore immediately out of date. Some analysts use prospective earnings to remove this historical bias.

If your target company is growing rapidly, then what was per share earnings of $4.30 this last reporting season, may become $6.30 this next. This gives the prospective earnings ratio of

$75/ $6.30 = 11.9 times

Much closer to our original quote of 10.5 times. This jump in prices could quite easily happen if a company had won an important contract. Something that would change earnings substantially.

For these reasons, price earnings is only one calculation in an arsenal of accounting formulas when assessing the price of a business.

To quote Warren Buffett (a smart investor) "Price is what you pay, value is what you get". Which means the more you pay the less value you're getting.

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