Fee Based Banking Services
Banks earn their income in two parts. One type of income is generated by undertaking risk i.e. by lending their deposits. This is called interest income and forms the major portion of any bank’s earnings. However, banks can also generate earnings from other sources wherein they do not have to lend money or collect interest. […]
Lifecycle of Public Private Partnership (PPP) Projects
In the previous articles, we have undertaken careful consideration of how public-private partnership (PPP) projects work. A lot of details have been provided about the execution stage of PPP projects. However, little is known about how these huge infrastructure projects come into being in the first place. In this article, we will have a closer […]
The Goodleap Business Model
When investors look at the list of companies that have become unicorns in the recent past, Goodleap tends to stand out. The company has stayed under the radar for a long period of time. It is only in 2021 that the company left the stealth mode and started publicizing some aspects of its business. It […]
Shares and Stock Market – An Overview
An organization in order to raise money divides its entire capital into small units of equal value. Each unit is called a share. A share is nothing but an indivisible unit of a company’s capital to be sold among individuals to increase profit of the organization. Shareholder An individual owning one or more than one […]
Regulatory Role Performed By the Central Bank
The two tiered system puts the central bank in control of the commercial banks. Therefore, the government authorities have delegated some of the regulatory responsibilities to the central bank. It is the job of the central bank to ensure that commercial banks are conducting their business in a manner which is considered ethical as well […]
The price to earnings ratio is the most fundamental of all market related ratios. It has been used for decades by stalwarts in the investment community. However, it is also the ratio that has come under maximum fire from the skeptics. A variety of measurements have been developed to compensate for what skeptics call the lack of correct information provided by the price earnings ratio. Almost all other market related ratios are a variation of the price to earnings ratio.
Price to Earnings Ratio = Current Market Price / Reported Earnings of the Company
The price to earnings ratio tells the investors how many rupees they are paying for every rupee in earnings that the company presently has. If the price to earnings ratio is 5, then investors are paying 5 rupees to get a stream of earnings of 1 rupee per year till perpetuity. This ratio therefore also implicitly tells the payback period which in this case would be 5 years.
There are a lot of assumptions that the price to earnings ratio implicitly makes. This is the reason that this ratio has come under a lot of criticisms from skeptics who think that price to earnings ratio provides a distorted image of what the reality of the company really is. The common assumptions are as follows:
The world is yet to see a company that has been able to generate stable earnings for an extended period of time. This is why the price earnings ratio may present reality to be different than what it really is.
Moreover the investment community may not enough data at hand to adjust these earnings and arrive at a figure which they think are fair earnings of the company. Hence, naive investors who only look at price-earnings ratios without looking at whether the earnings have been manipulated will possibly make wrong decisions based on this number.
The price to earnings ratio must be interpreted in the light of the fundamentals of finance. These fundamentals are the fact that an investment grows over a period of time. This growth pattern usually follows an exponential pattern which makes the phenomenon of compounding so important.
The fact that price to earnings ratio uses simple arithmetic division makes it unacceptable to many skeptics in the investment community.
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