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Price-to-Earnings (P/E) Ratio
The price-to-earnings ratio is the ratio used to value a company by calculating its current share price relative to its per-share earnings. This ratio denotes how much an investor is willing to pay for each $1 earnings per share of the company. Lowering the PE ratio with respect to the industry undervalued the market price of the share, while higher the PE ratio with respect to the industry overvalued the market price of the share, as this is considered one of the most important ratios for the comparative analysis of companies.
Price-to-Earnings (P/E) Ratio = Market Value per Share / Earnings per Share
Example: At a market price of $123.18, Tesla's P/E ratio is currently 37.95.
P/E Ratio = Market Value per Share / Earning per Share
P/E Ratio = $123.18 / $3.24
P/E Ratio = 37.95
This means that Tesla investors are willing to pay $37.95 per share for $1 earnings per share.
Interpretation of the P/E Ratio:
- The P/E ratio describes how much an investor is willing to pay for every $1 of earnings.
- If a company enjoys higher goodwill, brand name, reputation, and trust, then it will have a higher PE ratio.
- A company that the investor community believes is less risky and has a lower debt-to-equity ratio, thus a lower financial risk, has a high P/E ratio.
- A company with large-scale operations, well-diversified revenue streams, consistent earnings records, and a larger client base is thought to be less risky in terms of operational risk and thus commands a higher P/E ratio.
- A company with higher future growth prospects will have a higher P/E ratio.
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