Price/Earnings Ratio (P/E Ratio)

Price/Earnings Ratio is a measurement of how highly a share is valued - in other words 'its rating'.

It's a useful measure of comparison, since not all companies pay out the same proportion of their profits in dividends. Yet the money they retain in the company didn't vanish, it goes into 'the reserves' and it continues to belong to the shareholders. It's being retained in the business because the directors believe they can get a worthwhile return on it. So analysts like to be able to compare the share price with the earnings of the company.

The Price/Earnings Ratio (P.E. Ratio) is calculated by dividing the company's market capitalisation (its value) by its earnings. Put another way, the company's share price can be divided by its earnings per share to reach the same result.

Generally speaking, the stockmarket is prepared to put a higher price earnings ratio on a company which has the potential for above-average growth in profits and dividends than on a company which is only managing sluggish growth.

The P.E. ratio is also an often quoted term when talking about buying and selling businesses. To highlight the point above, a poorly managed business with poor prospects say in textiles, may make £1 million a year, but be sold for just £4 million because it's 'on a low rating' - (this is a P.E. of 4!).

Conversely, another business (say a technology company) may be thought to have great prospects. It too might be making £1 million a year, but because analysts have high hopes for the future, the business could be sold for say £30 million. This would give it a P.E of 30.

The higher the rating, the more highly valued the company - watch you don't overpay, although there is some truth in the expression 'you have to pay highly for quality'.

See Also: Online share dealing service Stockmarket Centre

Last Updated: July 2007 © Moneyextra.com

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