Definition

The Price to Earnings (PE) Ratio is a financial metric used to evaluate the relative value of a company's shares. It measures how much investors are willing to pay for each dollar of a company's earnings.

Formula

PE Ratio = Price per Share / Earnings per Share (EPS)

How to use the valuation method

The PE Ratio is used to assess whether a stock is overvalued or undervalued compared to its earnings. A high PE ratio may indicate that a stock is overvalued or that investors expect high growth rates in the future. Conversely, a low PE ratio might suggest that a stock is undervalued or that the company is experiencing difficulties.

Which industries it work best in

The PE Ratio works best in industries with stable earnings and consistent growth, such as consumer staples, utilities, and large-cap technology companies. These industries tend to have predictable earnings, making the PE Ratio a more reliable indicator of value.

Which industries it does not apply to and why

The PE Ratio is less applicable in industries with volatile or negative earnings, such as startups, biotech, and cyclical industries like mining or oil and gas. In these sectors, earnings can fluctuate significantly, making the PE Ratio less meaningful or even misleading.

Summary

The PE Ratio is a widely used valuation metric that helps investors determine if a stock is fairly valued based on its earnings. It is most effective in industries with stable earnings but less useful in sectors with volatile or negative earnings.