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The PE Ratio explained

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The PE Ratio, or P/E ratio, is shorthand for the Price : Earnings ratio of a company, which is calculated as the market capilisation of the company divided by the total annual earnings of the company, and simplistically reflects the number of years earnings which are contained in the market capitalisation (or alternatively calculated as the price for one share divided by the annual earnings per share).

The higher the P/E ratio of a company the more you are paying for each net unit of earnings. Companies which are expected to have higher earnings growth usually have a higher P/E ratio. If a company has a P/E ratio twice that of another company, then everything else being equal (especially expected earnings growth) the company with the lower P/E ratio is a more attractive investment. Investors are also willing to pay more for stable earnings than uncertain earnings (e.g. earnings due to high leverage).

There are various definitions of earnings which can be used in calculating the P/E ratio:

PE ratios as predictors of future returns

We can see that in the US at least, historic returns have been lower from a starting point of a higher PE (10 years). Shiller PE predicting 20 year returns

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