What Is A P/E Ratio?

Published in Investing on 30 November 2012

Two Fools take a quick look at P/E ratios.

In this video for novice investors, Andy Paul and Nate Weisshaar offer insight into how we value companies and how to use a price-to-earnings (P/E) ratio.

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guykguard 30 Nov 2012 , 10:13am

I'm sure that the two authors of the video know what a P/E ratio is, but by golly they explained it poorly enough.
The P/E ratio is a period or time based measure. It answers the question: at the price quoted per share, and at the reported earnings per share for the period, how many periods will it take to recover the price paid per share?
The authors say that the P/E ratio enables the investor to estimate the relative return of two or more shares, but they failed to say that, other things being equal, the fewer periods it takes to recover the price paid per share, the higher the return on the investment in the share is likely to be. It is the equivalent in investment appraisal of payback, with all its benefits and drawbacks.
Over many years I've listened to scores of definitions of the P/E ratio. Few ever get it absolutely right. The video is one more example. Sorry!

TMFTheSnake 30 Nov 2012 , 10:36am

guykguard

Excellent point, and you've provided a nice, concise definition, which while not materially different than my "how much I'm willing to pay for a company's earnings" (in my view) approaches the question from a slightly different angle.

However, I'll take this opportunity to reiterate one of the reasons I don't like to use P/E when valuing shares.

"how many periods will it take to recover the price paid per share"

This assumes all earnings are actual cash flow back to the shareholder, which is rarely the case. As pointed out in the video earnings can be manipulated in various ways and will often be different than the cash generated by the business. As value is based on actual cash returns, I'm much more interested in how much I am paying for a company's cash flows, or how long it will take for cash flows to return my investment (see what I did there?).

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