PE ratio

The price/earnings ratio (PE) is the most commonly used valuation measure. It compares the price of a share to the EPS. It directly relates the price of a share to the proportion of the company's profits that belong to the owner of that share.

One of the reasons for the popularity of the PE ratio is its simplicity. It is:

share price ÷ EPS

Headline or adjusted EPS is usually preferable to basic EPS. A diluted EPS is usually preferable to an undiluted one.

A higher PE means that the same share of a company's profits will cost a prospective shareholder more. There are usually reasons for a higher PE. It may reflect faster expected earnings growth, or lower risk earnings.

As investors are most interested in future cash flows, prospective PE and other future PEs are usually more important than historical PEs.

Some investors prefer to use historical PEs because they are based data that is factual and known with a high degree of certainty (creative accounting aside). The estimates used to calculate prospective PEs are much more uncertain. Some conservative value investors use a long term PE, this calculated using the average EPS over several previous years, as is the cyclically adjusted PE.

In order to make fair comparisons of companies with different year ends, and to use the most up to date information, one can use a PE based on the trailing twelve months earnings.

It is also useful to look at a relative PE against a company's sector or market.

PE is the most widely used valuation ratio and has the advantage of being comparatively simple. It is not the only valuation ratio — although many investors, even professionals, appear to think it is — and others are frequently more useful. For example, the closely related PEG ratio provides a crude adjustment for growth, while EV/EBITDA is not distorted by capital structure.

Discounted cash flows are theoretically the most correct form of valuation, but are harder to do.