Price to Earnings

Price to earnings ratio shows the attractiveness of the company for the investor. Higher ratio shows that investor is ready to pay higher price for the earnings of the company and that he is expecting the growth of the company in the future. Some investors may think that the high price for earnings of the company shows that the company is overvalued. Lower ratio shows that it is cheaper to buy earnings of a firm.

This ratio may vary depending on the type of the company and the sector where it works. It is held to be cheap, if the price to earnings is less than 10 and this might show pessimistic expectations for the company. It is also said that it is expensive if the ratio is higher than 20, but it shows optimistic perspectives of the company. This ratio can be even higher than 20 for young and fast growing companies, because the earnings of them are expected to increase. For companies that are very profitable, price to earnings ratio of 10 will be too expensive, because earnings per share are very high.

Let's take an example of different types of companies, to clear out how the ratio changes. Assume that there is a company that own 10.000 shares which has the price of 100 Euros for one share. This company earned 100.000 Euros for the calculated period. Earnings per share for this situation will be 10 Euros, and Price to earnings ratio is equal to 10. It means that investor, who buys this share will pay ten times more than one share can earn in the calculation period. Let's say, that the company is growing one and the price of share is increasing from 100 to 150 because of increasing demand and positive expectations. Now price to earnings ratio is 15, which shows higher price for the future earnings. And for the last example, let's imagine that the profitability of the company suddenly increased from 100.000 Euros to 150.000 Euros, but the price of share was stable and didn't change. For this situation Earnings per share grew up to 15 Euros per share and Price to earnings ratio is equal to 6,7. It shows that for the same price of share you can get more profit of the company.

As you could understand - the meaning of Price to earnings ratio is equivocal. Lower ratio shows that it is cheaper to buy the earnings of the share and it is more affordable for the investor, but higher ratio is more attractive for the investor, because it is expected to bring higher earnings from the shares in the future. So it is only for every investor individually to decide whether this ratio is "good" or not. Anyway - this ratio must be checked among other ratios and in a period of time, because changes of the ratio show the trends where the company is going and if it's worth investing in it or not.

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