# Price Earnings Ratio

Price-Earnings Ratio (also known as the P/E multiple) is calculated by taking the market price of the stock and dividing it by earnings per share. It is calculated as:

Market price of the stock
Earnings per share

This ratio indicates the relationship between the market price of the stock and its earnings by revealing how the earnings affect the market price of the firm's stock. It is the most popular financial ratio in the stock market for secondary market investors.

The price earnings ratio indicates the expectation of equity investors about the earnings of the firm. It is used for valuation of the firm and its stock. The earnings of the firm and the market price of the stock being related indicate the investor the price they are paying for each unit of the income available to them. Higher the P/E ratio, the expensive it is to own the stock. Companies with high growth rates and potential generally have a higher P/E ratio as compared to companies with lower earnings growth. By comparing the P/E ratios of two companies, one can assess the relative valuation of the company. Other things remaining equal, a company with lower P/E ratio is preferred over the one with a higher P/E ratio. One of the drawbacks of the P/E ratio is that it based on the net profit as reported in the profit and loss account. If the companies have inflated profits by any means, the ratio may be misleading.

Example:

Assume that the stock price of a company is \$36 and the company reported net earnings of \$600,000 during the period. It has 100,000 shares outstanding at the end of the period.

The earnings per share of the company would be \$6 (\$600,000 / 100,000 shares) and the P/E ratio would be:

\$36
\$6

6.0

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