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How the PE ratio is calculated

by , 03 September 2013

The price earnings ratio (PE ratio) is a much quoted number in finance. It gives you an idea of whether a share is overvalued or undervalued. Let's have a closer look at how you can calculate the PE ratio…

In your quest to find winning shares, the PE ratio can play its part.

This ratio can tell you if a share is cheap or expensive, Tim Bennett explains in MoneyWeek.

The financial press regularly quote companies’ PE ratios. You can also find PE ratios for shares on stockbroker sites and financial sites like Fin24.

Let’s see how you can work out the PE ratio…

So let’s say you get the chance to buy a share for R50.

You need to know the earnings per share to calculate the PE

You also know that last year, the firm in question generated profits of 500c per share. This is the earnings per share (the annual net profits divided by the number of shares in issue).

This means, obviously enough, that investors are currently willing to pay R50 for every 500c of earnings (profits) the company makes.

The PE ratio is simply the price of the share, divided by earnings per share.

In this example, it’s R50 divided by 500c = 10.

Put another way, if earnings per share stay at 500c a year for the foreseeable future, it will take ten years (ignoring inflation) to repay your original investment of R50.

In this case, we’ve used the past year’s earnings figure. This is the ‘trailing’ PE.

You could instead use an estimate of the company’s earnings for next year, which gives you a ‘forward’ PE.

The risk here is that actual earnings are the basis of a ‘trailing’ PE, whereas an estimate is the basis of the ‘forward’ PE, which may be wrong.

There you have it, how you can calculate the PE ratio.

How the PE ratio is calculated
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