So many people invest in shares, in fact nearly every Australian worker has some form of shares at the moment, through superannuation. If you haven’t gone to the extent of actually purchasing shares yourself, then there are a few things you will need to understand before taking ‘the plunge’.

To help you with the basics of understanding shares, I’ll run a short post series. If you have any feedback or suggestions on what you would like to hear more about, please post a comment below and I’ll post the information for you.If you go to the ASX website, and click on shares to search for a company, you will find the following facts: This first post is about Price Earnings Ratios (P/E ratio).

What Does Price-Earnings Ratio - P/E Ratio Mean?
A valuation ratio of a company’s current share price compared to its per-share earnings.
Calculated as: Price-Earnings Ratio (P/E Ratio)

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

The Eearnings Per Share is usually from the last four quarters (also called trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four.

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn’t tell us the whole story by itself. It’s usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company’s own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

The P/E is sometimes referred to as the “multiple”, because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, that would mean that an investor is willing to pay $20 for $1 of  current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

I hope this post helped you understand the P/E Ratio, and be sure to keep an eye on the next post.

PD