Price to Earning or PE is the most crucial business valuation ratio used for equity investment.
It is the ratio of last traded price of a share to its earnings per share. For example the last traded price of Ashok Leyland is 93 and its annual Earning Per Share is Rupees 6.5. Hence its price to earning ratio is 14.3 which is 93 divided by 6.5.
Right understanding of PE can completely redefine your approach towards share market investment.
Imagine if you want to buy a business, let’s say a coffee shop, Price of this coffee shop is 12lacs and it generates annual profits of 1.2lacs.
Hence PE for this business will be the ratio of price paid to buy the business to its annual earnings. In this case it will be 12 divided by 1.2 which is 10.
So you are actually paying 10 times the annual earnings of the business or In other words you are paying future earnings of 10 years in advance.
Alternatively, as this business is generating profit of 1.2lacs per year, it will take 10 years for this business to recover the initial investment of 12lacs.
Hence PE can also be considered as Simple Pay back Period.