Thread by @stocktalk_in

📕 WHAT EXACTLY IS P/E RATIO

🔸 Let’s try to avoid textbook definitions and formulae and instead understand the core concept of P/E ratio in simple words.

🔸 Assume that you and your best friend decide to start a new business venture.

(1/n)

🔸 Each one of you contributes ₹50,000 towards the business as starting capital.

🔸 In return each of you get 5,000 shares of ₹10 each.

🔸 Now here’s the capital structure:
- Total capital: ₹1,00,000
- No. of shares: ₹10,000
- No. of shareholders: 2 (50% each)

(2/n)

🔸 After a successful year in business, you generate a profit (earnings) of ₹25,000.

🔸 That means as 50% owner of the business, you get to keep ₹12,500.

🔸 Let’s calculate Earnings Per Share (EPS)

EPS = Earnings / No. of shares

= 25,000 / 10,000

= ₹2.5

(3/n)

🔸 So now that you have calculated the EPS you now exactly know how much each one of the 5000 shares you own is earning for you.

🔸 You get excited and tell this to another friend of yours and you also tell him how your business is going to grow in the coming years.

(4/n)

🔸 After listening to you, your friend goes home and thinks, wow even I want a share of the profits his business is going to make.

🔸 But he knows that now that your business is successful, he just cannot buy the shares of your company at base rate of ₹10 each share.

(5/n)

🔸 So he comes to you the next day and offers you to buy 1000 shares of your company at ₹15 per share.

🔸 He has added a premium of ₹5 per share over your base rate of ₹10 per share.

🔸 Here come’s the Price to Earnings (P/E) ratio.

P/E = Price / EPS

= 15 / 2.5

= 6

(6/n)

🔸 That means your friend is now willing to pay 6 times extra to buy your shares and earn from them in equal proportion as you.

🔸 P/E is also called as a value multiplier. In our story, it’s 6x.

🔸 It denotes how much extra new shareholders are willing to pay.

(7/n)

For everyone wanting to read more about this P/E example in further detail, read this 👇

stocktalk.in/what-is-the-pe…