Question

What does the P/E ratio indicate about a company? How reliable of an indicator is the ratio?

Answer 1

The P/E ratio can be calculated as price of the stock / earnings per share.

It indicates weather a company is undervalued or overvalued.

If a P/E ratio is high it indicates that the company overvalued ,if the P/E ratio is low,it indicates that the company is undervalued. The P/ E ratio indicates how much the investors are willing to pay for a company. If the P/E ratio is high,it can indicate either that the investors are confident about the future prospects of the company and hence willing to pay a higher price. A low P/E can also indicate that , the investors are not very confident about the future of the company.

No the P/E ratio is not always reliable. It may look simple to calculate but it tells nothing about the growth rate of a company , which is a problem. Investors will be more willing to buy a stock which has a higher growth rate ,even if it is overvalued.

The denominator of the ratio, which is earnings is difficult to measure and hence this ratio can be misleading.