The P / E ratio is very easy to calculate: the current share price is divided by the earnings per share. The P / E ratio indicates how many times the profit attributable to a share is currently being valued. In other words, it describes the number of years in which the company would have earned its market value if profits were constant. But where does the winning number come from?
The P / E ratio is usually based on the estimated profit for the current or the next year. This is an attempt to do justice to the expected profit development, because information from the current period is already anticipated in the prices on the stock exchange. The old stock market saying “The future is traded on the stock exchange” also applies to the P / E analysis. Profit expectations are sometimes deceptive This, however, is also the biggest problem of the P / E ratio: the analysts’ earnings estimates are subject to great uncertainties and in certain market phases – especially at the beginning of an economic downturn – are unusable. Only the price-earnings ratios are secured, which are based on the profit of past business periods. Normally, however, the P / E allows statements regarding the overvaluation or undervaluation of a share. The lower the P / E ratio, the cheaper the share appears compared to the overall market or to the shares of competitors. Single-digit earnings: cheap or dangerous?
However, there is no reliable basic rule from which P / E ratio a share can be regarded as “fairly valued”. P / E ratios can vary widely depending on the market phase and industry. Even stocks with high double-digit P / E ratios do not have to be expensive if the company in question has a corresponding profit growth. A company at the breakeven point can appear extremely expensive because the value in the denominator is still very small. On the other hand, a low P / E can sometimes be a warning sign. Because at times the market is already significantly further than the average analyst estimates: In anticipation of falling profits, the share price has fallen, which means that the long-outdated P / E ratio makes the paper appear optically favorable. Numerous investors have already fallen victim to this “optical illusion”.
P/E= Share Price/ Earnings per Share
Source: Seeking Alpha