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The formula for the price to earnings ratio, also referred to as the P/E Ratio, is the price per share divided by earnings per share. The price to earnings ratio is used as a quick calculation for how a company's stock is perceived by the market to be worth relative to the company's earnings. A higher price to earnings ratio implies that the market values the stock as a better investment than if there was a lower price to earnings ratio, ceteris paribus. The increased perceived worth is due to news, speculation, or analysis from investors that the stock has a higher growth potential for the future.
The price to earnings ratio varies across different industries and also different countries. When comparing the price to earnings ratio among companies, it is important to compare within the same industry and country. Some industries are generally considered to have high growth expectations for the future as opposed to other industries that have a steady and established growth rate.
Earnings per share in the price to earnings ratio is a company's net income divided by the weighted average of outstanding shares. It is important to consider that a company's net income can vary depending on the company's accounting methods. When comparing two different companies that use different inventory valuation and depreciation methods, the price to earnings ratio for both companies can not be exactly compared, as all things are not held constant.
There are a few issues to consider when using the price to earnings ratio. As previously stated, different companies may use different accounting methods which can affect net income. This, in turn, will affect the price to earnings ratio when trying to compare companies.
Another issue with the price to earnings ratio is companies with a net loss. The denominator of the formula, earnings per share, relies on a company having a net income as opposed to a loss.
Also, the price to earnings ratio is self-referencing, in that it is calculated based on the price of the stock. A specific company may have a high price to earnings ratio, but based on stock valuation methods, some may consider the stock to be overvalued. In this situation, a stock with a higher price to earnings ratio may actually be a poor investment. The price to earnings ratio is simply a perception of the market by investors, and relies on efficient market theory as the sine qua non of its absolute accuracy.