The Price to Earnings Ratio, or PE Ratio, is the primary valuation ratio used by most equity investors. It is the price per share divided by earnings per share. This is measured on a 1 year rolling basis and earnings are diluted and normalised.
A high PE ratio means that investors are paying more for each unit of Earnings, so the stock is more expensive compared to one with a lower PE ratio. The PE ratio can be seen as being expressed in years, in the sense that it shows the number of years of earnings which would be required to pay back the purchase price, ignoring inflation.
Investors have a tendency to overreact becoming enamoured with glamour stocks (pushing their PE too high) while becoming disenchanted with value stocks (pushing their PE too low). Research has shown that low PE ratio stocks tend to outperform high PE stocks in the long run. On the other hand, there are many investors who believe that you should 'pay up for quality' in the same way people pay for jewellery - the best growth stocks therefore rarely trade for cheap PE multiples.
Unlike the EV/EBITDA multiple which is capital structure-neutral, the price-to-earnings ratio reflects the capital structure of the company in question. The reciprocal of the PE ratio is known as the Earnings Yield.
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