#### June 3rd, 2010 · Dallas TX, USA -

One of the most widely used profitability ratios by Analysts and investors to judge a company’s performance is **P/E ratio**. It is the ratio of the stock market price of the stock and the earnings per share (EPS).

P/E ratio = (Market price per share/Earnings per share)

For example, if the Earnings per share of company is $100 and the stock price is $50, then

P/E ratio = $(50/100) =0.5

Remember P/E is just a ratio and has no units attached to it.

EPS is calculated by dividing the profit after tax (PAT) by the number of shares outstanding.

EPS = (PAT/Number of shares outstanding)

For example, if the PAT for a company is $100 million and the number of shares outstanding is 50 million, then

EPS = ($100/50) =2

EPS is another profitability ratio which is widely used along with P/E ratio.

P/E ratio reflects the investors’ expectation about the growth in the firms’ earnings. P/E ratio differs from sector to sector. For example, P/E ratio of manufacturing sector would be different from the P/E ratio of the Banking sector. Even companies in the same sector would have different P/E ratio. To judge the performance of a company an Analyst should compare the firms’ P/E ratio with the industry P/E ratio and its competitors.

The P/E ratio calculated on the last four quarters’ earnings is known as trailing P/E. It is also calculated on the expected future earnings of the company. Some people also use the P/E ratio to value the share of companies. For example, the P/E multiplier of a company is 15 and the company expects the next year EPS to be $20. The expected value of the stock would be: $20*15=$300.

P/E ratio can also be interpreted as the amount an investor is willing to pay for each dollar of earnings by the company. So, a high P/E ratio means that investors are expecting better earnings from the company. P/E ratio can be misleading at times and one should not base its decision on P/E ratio only. A high P/E ratio does not necessarily mean that the share prices are high but the earnings are low. EPS is depended on PAT and PAT can be manipulated to the advantage of the company. Thus it is very difficult to interpret EPS meaningfully and rely on EPS and P/E ratio as measures of performance.

**Tags:** Investment