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Good Price To Earning Ratio: How Does a Company Earnings Translate Into A Return For The Shareholder

Referencing Styles : APA | Pages : 2
  • University: University of Technology Sydney
  • Country: US

What's a good price to earnings ratio?

The price to earnings ratio specifies a share’s predictable price on the basis of its earnings. The market value per share of a company rises along with the rise in the company’s earnings per share. A company having a high price to earnings ratio is an indicator of the company’s positive future performance and it means the investors are prepared to pay more for the shares of the company. On the other hand, a company having a lower price to earnings ratio is considered as an indicator of ineffective or poor future as well as current performance. This can lead to poor investment. In common, investors expect better performance and growth of the company in future in the presence of higher price to earnings ratio. It is an indicator of the fact that the companies with major business losses have poor price to earnings ratio. These aspects indicate that a higher price to earnings ratio is good for the investors because it indicates a company’s positive future and current performance.

How does a company's earnings translate into a return for the shareholder?

Earnings have the ability to drive the stock prices and the investors eagerly wait for the announcement of the companies’ earnings. Two aspects need to consider in this case; they are how earnings should be calculated and how to turn these earnings into the return for the shareholders. The concept of cash flow is crucial here where it refers to the expected cash due to owe an asset. Cash flows are obtained from earnings to the investors and this can also be considered as ‘net income’ or ‘profit’. The difference between a company’s revenues and costs is known as earnings. All the costs spent by the company for the production of the products are included in the costs. There are several forms through which earnings flow to the shareholders, but dividend is considered as the main channel. More specifically, earnings can be considered as an intellectual term in the financial statements while dividend is the real cash arriving in the shareholders’ account as return for them. In this manner, a company’s earnings translate into the return for the shareholders.

Why people says that, "don’t believe in P/E"?

Price to Earnings ratio or P/E ratio has gained popularity because it is considered as an indicator of a company’s earnings yield. However, this belief is based on theory and it does not work in the real world in the described manner. The presence of several flaws can be seen in this price to earnings metric. Over the years, this ratio has not been able in providing the desirable results to the invertors regarding the stocks. For this reason, many people do not believe in P/E ratio.

Is that a correct statement?

In the presence of certain key flaws in the price to earnings, the above statement of "don’t believe in P/E" is considered as correct. These flaws are shown below:

  1. Earnings of a company can be manipulated at the company level unlike other indexes such as dividends and cash flows. It implies that price to earnings ratio can be biased based on the accounting treatment adopted by the company for that particular item. The differences in accounting standards countrywide only adds to this issue. In case using earnings as only indicator of the profitability of a firm is unsafe, then it is highly dangerous to use price to earnings ratio as a valuation indicator without considering other metrics. For example, a low price to earnings ratio can reflect the market expectation of a bad news of a company on the way; it means that a seemingly striking priced stock can become available for the investors. Therefore, the price to earnings ratio can be misleading and completely worthless if it is not compared to the company’s history, sector and the whole industry.
  2. The use of price to earnings ratio for the investors in small cap stocks is worrying, especially companies involve in the dealing of natural resources. For example, there will not be any existence of the price to earnings ratio in the companies with little or no earning. Therefore, depending on the price to earnings ratios of these companies would misled the investors.
  3. Through emphasizing on the price/market capitalization, price to earnings ratio does not consider the impact of debt; and this makes the valuation of EBITDA or free cash flow inferior.

How important is P/E when considering which stocks to buy?

Price to earnings ratio is considered as one of the most widely used took for stock valuation and making stock buying decisions. This ratio plays a significant role in considering which stocks to buy because it shows how expensive or cheap a stock is. In case price to earnings ratio of a stock is 12, it implies the willingness of the investors in paying 12 times the company’s earnings for buying that stock. On the other hand, stocks having price to earnings ratio of less than 10 are considered as cheap and the investors get good opportunity to buy these stocks. Higher price to earnings ratio works as an indicator of high growth in earnings of the companies and investors can make the buying decision of these stocks.

How to determine market capitalization the stock price?

Market Capitalization is a measure used by the investors and financial analysts for estimating a firm’s market value. The market capitalization can be determined from the following formula:

Market Capitalization = Number of Outstanding Shares × Market Price of Each Share

For example, ABC Corporation has 10 million outstanding shares and it is trading at $120 per share. Then, the market capitalization of ABC Corporation is ($120 × 10 million outstanding shares) or $1.2 billion. The figures of market capitalization is not fixed because this can be changed due to the daily changes in stock price and long-term stock market trends. In addition, market capitalization of a firm can also be changed due to management’s decisions. For instance, market capitalization increases due to the decision of the management to issue new shares.

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