“Price to Earnings Ratio (P/E) (or price multiple or earnings multiple) is the most commonly used valuation method by investors. It measures how much investors willing to pay for every dollar of earnings the company generates.
If a company’s P/E ratio is 10, it means investors are willing to pay $10 for every $1 the company generates. Similarly, if a company’s stock price is $100 and its earning per share is $20, then its P/E ratio is 5.
P/E = Share Price / Earnings per Share
Interpretation of P/E Ratio
The P/E ratio tells investors two things:
Firstly, assuming everything remains constant, a company with a P/E ratio of 10 technically means it will take ten years for investors to get back their initial investment based on the company’s current earnings.”
I don’t understand this. Why would people be willing to pay $10 for every $1 the company generates? and 10 years to get back initial investment? then is it really called an investment if it takes 10 years to get back the same amount you started with?
Sorry if the harsh language offended anyone but I just don’t get this concept which frustrates me.
Hi Shu Fang,
This assume based on the scenario that the earning per share (EPS) remain at $1 for the next 10 years. As you are buying into a growing business, most of the time the EPS will grow as the times goes. Hence, you are not actually paying for 10x PE but rather lesser in the future.
put it in another way..even not the scenario that victor has described, you will get back yr original investment after 10 years, that is 10% per year. Not forgetting..after 10years, you will continue to get 10% free money every other year. In theory, this is considered a good investment to me. If as Victor mentioned…business grows, profit grows…then it is going to be a wonderful investment as your investment will be growing more than 10% per year and ROI will be even better.
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