Ask Colin

The PE ratio is often said to be the number of times you pay for earnings. But you cannot spend earnings. Wouldn't price to dividend be better?

The PE ratio concept is a way of valuing a company. If you buy any kind of business, it will often be valued as how many times earnings you are paying for it - or how many years you would take to get your money back from the earnings. If you are buying all of a private company, quite clearly this concept is easy to understand because all of the earnings can be taken out each year if you choose to.

However, in most listed public companies, some of the earnings are retained in the business, rather than being paid out in dividends. The retained earnings stay in the business and belong to the shareholders - they are accounted for as undistributed profits and can be paid out later if the directors and shareholders wish. The idea is that if earnings are retained, the net assets of the company increase and so does its value. The market should theoretically recognise this in an increased share price equivalent to the retained earnings per share. So, you theoretically get a dividend, plus and increase in share price, the two adding up to the earnings. In reality this theory is only loosely applicable in practice, because so many other things affect the share price, so it is hard to separate out just the one influence on it.

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