Price to Earnings Ratio (P/E Ratio) – What it Is & How to Calculate
What Is Price to Earnings Ratio – P/E Ratio?
The price to earnings ratio (P/E ratio) is a quick measure for valuing a company. It measures the company’s current share price in relation to its earnings-per-share (EPS). The price to earnings ratio is also known as the price multiple or the earnings multiple. The P/E ratio provides a numeric representation of the value between the stock price and earnings.
PE ratios are used by investors and analysts to compare the relative values of a company’s share prices. It can be used to compare a company against its own historical record. It can also be used to compare companies against one another as well as different markets against one another or over time.
- The price to earnings ratio (P/E ratio) relates a company’s share price to its earnings per share.
- A high P/E ratio could mean that a company’s stock is over-valued, or else that investors are expecting high growth rates in the future.
- Companies that have no earnings or that are losing money do not have a PE ratio since there is nothing to put in the denominator.
- Two kinds of PE ratios – forward and trailing PE – are used in practice.
P/E Ratio Formula Explanation
The basic P/E formula takes the current stock price and EPS to find the current P/E. EPS is found by taking earnings from the last twelve months divided by the weighted average shares outstanding. Earnings can be normalized for unusual or one-off items that can impact earnings abnormally.
The justified P/E ratio is used to find the P/E ratio that an investor should be paying for. It is based on the companies dividend and retention policy, growth rate, and the investor’s required rate of return. Comparing justified P/E to basic P/E is a common stock valuation method.
Why Use the Price Earnings Ratio?
Investors want to buy financially sound companies that offer a good return on investment (ROI). Among the many ratios, the P/E is part of the research process for selecting stocks, because we can figure out whether we are paying a fair price. Similar companies within the same industry are grouped together for comparison, regardless of the varying stock prices. Moreover, it’s quick and easy to use when we’re trying to value a company using earnings. When a high or a low P/E is found, we can quickly assess what kind of stock or company we are dealing with. (Source: corporatefinanceinstitute.com)
High P/E Ratio
Companies with a high Price Earnings Ratio are often considered to be growth stocks. This indicates a positive future performance. As a result, investors have higher expectations for future earnings growth and are willing to pay more for them. The downside is that growth stocks are often higher in volatility. This puts pressure on companies to do more to justify their higher valuation. For this reason, investing in growth stocks tends to be seen as a risky investment. However, stocks with high P/E ratios can also be considered overvalued.
Low P/E Ratio
Companies with a low Price Earnings Ratio are often considered to be value stocks. They are considered undervalued because their stock prices trade lower relative to their fundamentals. This mispricing can indicate great bargains and prompt investors to buy the stock before the market corrects it. Investors make a profit as a result of a higher stock price. Examples of low P/E stocks can be found in mature industries that pay a steady rate of dividends.
P/E Ratio Example
If Stock A is trading at $30 and Stock B at $20, Stock A is not necessarily more expensive. The P/E ratio can help us determine, from a valuation perspective, which of the two is cheaper. If the sector’s average P/E is 15, Stock A has a P/E = 15 and Stock B has a P/E = 30, stock A is cheaper despite having a higher absolute price than Stock B because you pay less for every $1 of current earnings. However, Stock B has a higher ratio than both its competitor and the sector. This might mean that investors will expect higher earnings growth in the future relative to the market. The P/E ratio is just one of the many valuation measures and financial analysis tools that we use to guide us in our investment decision, and it shouldn’t be the only one. (Source: corporatefinanceinstitute.com)
Price to Earnings Ratio – What it Tells You
Investors often look at a company’s price to earnings ratio to determine whether or not to invest. The ratio is simply calculated by taking the market value per share divided by the earnings per share of a company. When the P/E ratio is calculated across a period of four previous quarters, it’s called a trailing P/E. This is the most common measure as it uses actual earnings for the calculation. When the price to earnings ratio is calculated using estimated net earnings of upcoming quarters, it’s called a future P/E.
The P/E ratio shows how much growth investors expect from companies they invest in. A high ratio indicates that investors are paying much more per share than the company is earning. This is common in new businesses with a lot of investment capital, like tech start-ups. Lower ratios indicate that growth has slowed, but that doesn’t necessarily mean the company is failing. Often, a lower P/E ratio may mean the company has matured and solidified its market share.
The price to earnings ratio also can be used to gauge the market as a whole. In that case, P/E ratios from different companies within the same industry are examined over the same period. This kind of comparison can help an investor determine if a given company is over- or undervalued.
Why the Price to Earnings Ratio Is Important
The price to earnings ratio is the share price divided by earnings per share. The resulting number tells you how much you are paying per dollar that the company earns. For example, a ratio of 15 means that investors are willing to pay $15 for every dollar of company earnings. This is why the P/E ratio is sometimes referred to as the earnings multiple or price multiple.
You generally use the P/E ratio by comparing it to other P/E ratios of companies in the same industry. You can also compare it to past P/E ratios of the same company. If you are comparing same-sector companies, the one with the lower P/E may be undervalued. Or if you’re looking at past data for one company, a higher number could mean it’s no longer a bargain. Ultimately, there’s no hard-and-fast rule for what is a good P/E ratio. But in general, many value investors consider that lower is better. (Source: smartasset.com)
Forward Price To Earnings Ratio
The forward (or leading) P/E uses future earnings guidance rather than actual past earnings figures. It is sometimes called the estimated price to earnings. This forward-looking indicator is useful for comparing current earnings to future earnings. It helps provide a clearer picture of what earnings will look like – without changes and other accounting adjustments.
However, there are inherent problems with the forward P/E ratio. It is an estimate and not an actual earnings result. Companies could underestimate earnings in order to beat the estimate P/E before the next quarter’s earnings are announced. Other companies may overstate the estimate and later adjust it going into their next earnings announcement. External analysts may also provide estimates, which may diverge from the company estimates, creating additional confusion.
What is the Formula for the Forward P/E Ratio?
The formula to calculate the forward P/E ratio is the same as the regular P/E ratio formula, however, estimated (or forecasted) earnings per share are used instead of historical figures.
Forward Price to Earnings = Current Share Price / Estimated Future Earnings per Share
For example, if a company has a current share price of $50, and next year’s EPS is expected to be $2.50, then the company’s forward P/E ratio is 20.0x.
Trailing Price To Earnings Ratio
The trailing P/E relies on past performance by dividing the current share price by the total EPS earnings over the past 12 months. It’s the most popular P/E metric because it’s the most objective. Of course, it assumes the company reported earnings accurately. Some investors prefer to look at the trailing P/E because they don’t trust earnings estimates. But the trailing P/E also has its share of shortcomings. You cannot accurately predict a company’s future performance based on past earnings performance.
Investors should thus commit money based on future earnings power, not the past. The fact that the EPS number remains constant, while the stock prices fluctuate, is also a problem. If a major company event drives the stock price significantly higher or lower, the trailing P/E will be less reflective of those changes. The trailing P/E ratio will change as the price of a company’s stock moves, since earnings are only released each quarter while stocks trade day in and day out. As a result, some investors prefer the forward P/E. If the forward P/E ratio is lower than the trailing P/E ratio, it means analysts are expecting earnings to increase; if the forward P/E is higher than the current P/E ratio, analysts expect a decrease in earnings. (Source: investopedia.com)
Trailing P/E Ratio Uses
The trailing P/E ratio accounts for a company’s actual earnings instead of its projected earnings. It is considered one of the most accurate ways of determining how valuable a company actually is. This is because it uses actual earnings data for the prior twelve months.
- Accurate Valuation – The trailing P/E ratio is most commonly used because it offers the most accurate valuation of a company, using historical earnings in comparison to current prices.
- Determining the P/E ratio is important for investors because it helps them get a better understanding of what they get for their investment. A good profit margin for a small price is a bargain.
- The forward P/E ratio is less commonly used because it compares current prices to projected earnings in the future. The projected numbers can change or be adjusted or manipulated to help the company look more attractive.
Stock Valuation using Price to Earnings Ratio
The price-to-earnings ratio or P/E is one of the most widely-used stock analysis tools used by investors and analysts for determining the stock valuation. In addition to showing whether a company’s stock price is overvalued or undervalued, the P/E can reveal how a stock’s valuation compares to its industry group or a benchmark like the S&P 500 Index.
Growth stocks are associated with high-quality, successful companies whose earnings are expected to continue growing at an above-average rate relative to the market. These stocks generally have high price-to-earnings (P/E) ratios. The open market often places a high value on growth stocks; therefore, growth stock investors also may see these stocks as having great worth and may be willing to pay more to own shares. Investors who purchase growth stocks receive returns from future capital appreciation, rather than dividends. Although dividends are sometimes paid to shareholders of growth stocks, it has historically been more common for growth companies to reinvest retained earnings in capital projects. At times, growth stocks may be seen as expensive and overvalued, which is why some investors may prefer value stocks, which are considered undervalued by the market.
Value stocks are those that tend to trade at a lower price relative to their fundamentals. These stocks generally have good fundamentals, but they may have fallen out of favor in the market and are considered bargain priced compared with their competitors. They may have prices that are below the stocks’ historic levels or may be associated with new companies that aren’t recognized by investors. It’s possible that these companies have been affected by a problem that raises some concerns about their long-term prospects.
Value stocks generally have low current price-to-earnings ratios. Investors buy these stocks in the hope that they will increase in value when the broader market recognizes their full potential, which should result in rising share prices. Thus, investors hope that if they buy these stocks at bargain prices and the stocks eventually increase in value, they could potentially make more money than if they had invested in higher-priced stocks that increased modestly in value.
Growth and value are styles of investing in stocks. Neither approach is guaranteed to provide appreciation in stock market value; both carry investment risk. The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Investments seeking to achieve higher rates of return also involve a greater degree of risk.
Absolute vs. Relative Price to Earnings Ratio
Analysts may also make a distinction between absolute P/E and relative P/E ratios in their analysis.
The absolute P/E is simply the stock price divided by EPS. In other words, it’s the same as the P/E ratio. The numerator of this ratio is usually the current stock price, and the denominator may be the trailing EPS (TTM), the estimated EPS for the next 12 months (forward P/E) or a mix of the trailing EPS of the last two quarters and the forward P/E for the next two quarters. The absolute P/E represents the P/E of the current time period. For example, if the price of the stock today is $50, and the TTM earnings are $2 per share, the P/E is 25 ($50/$2).
The relative P/E compares the current absolute P/E to a benchmark or a range of past P/Es over a relevant time period, such as the past 10 years. The relative P/E shows what portion or percentage of the past P/Es the current P/E has reached. It usually compares the current P/E value to the highest value of the range, but investors might also compare the current P/E to the bottom side of the range, measuring how close the current P/E is to the historic low.
The relative P/E will have a value below 100% if the current P/E is lower than the past value (whether the past high or low). If the relative P/E measure is 100% or more, this tells investors that the current P/E has reached or surpassed the past value. (Source: investopedia.com)
Other P/E Ratios
Some analysts feel the P/E ratio has limitations. There are other versions of the P/E ratio that are designed to overcome some of those shortcomings.
The price/earnings to growth ratio or PEG ratio is a stock’s price-to-earnings (P/E) ratio divided by the growth rate of its earnings. It helps investors arrive at a stock’s value but also factors in a company’s expected earnings growth over a given time period.
The forward PEG Ratio is based on expected growth for EPS. This number is calculated by dividing the P/E ratio by the expected earnings growth rate. This ratio helps investors predict if a company is overvalued based on expected growth estimates.
Limitations of Using the P/E Ratio
The price to earnings ratio comes with a few important limitations that are important to be aware of. Investors may often be led to believe that there is a magic metric that will provide complete insight into an investment decision. Sadly, this is virtually never the case.
- Zero or Negative Earnings – New companies that aren’t yet profitable, and have no earnings, or negative earnings per share, pose a challenge when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say there is a negative P/E. Others assign a P/E of 0. Most just say the P/E doesn’t exist, not available—N/A. Until there is an EPS number to put into the denominator, P/E is not interpretable.
- Apples-to-Apples Comparison – One primary limitation of using P/E ratios emerges when comparing P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors. This can be due both to the differing ways companies earn money and to the differing timelines during which companies earn that money.
- Same Industry or Sector – One should only use P/E as a comparative tool when considering companies in the same sector. This kind of comparison is the only kind that will yield productive insight. Comparing the P/E ratios of a software developer and an energy company, for example, may lead one to believe that one is clearly the superior investment, but this is not a reliable assumption.
- Limited for Valuation – Finding the true value of a stock cannot just be calculated using current year earnings. The value depends on all expected future cash flows and earnings of a company. Price Earnings Ratio is used as a good starting point, but it means little just by itself. An investor must dig deeper into the company’s financial statements and use other valuation and financial analysis methods to get a better picture of a company’s value and performance.
Pros & Cons of the Price to Earnings Ratio
There are many pros and cons of the P/E ratio:
- Handy to Calculate – Readily available for most stocks
- Quick Estimate – Helps investors quickly estimate the value of a stock
- Comparison Tool – Helps investors compare a stock among other stocks, industries, indices, etc.
- Superficial – Doesn’t provide a thorough or complete analysis of a company’s stock
- Accuracy – The ratio can be manipulated with varied accounting practices
- Historical Limits – Not updated in real-time. It’s based on earnings figures from the past
- Debt and Cash – Doesn’t take into account a company’s debt (or cash)
Price to Earnings Ratio – Bottom Line
It’s a good idea for investors to understand the P/E ratio and how to use it to evaluate share prices. But it’s only one of many available metrics. It shouldn’t be used alone, and it shouldn’t be used to compare companies that are in different businesses.
An individual company’s P/E ratio is much more meaningful when taken alongside P/E ratios of other companies within the same sector. An energy company may have a high P/E ratio, but this may reflect a trend within the sector rather than one merely within the individual company. An individual company’s high P/E ratio, for example, would be less cause for concern when the entire sector has high P/E ratios.
Also, a company’s debt can affect both the prices of shares and the company’s earnings. Leverage can skew P/E ratios as well. For example, suppose there are two similar companies that differ in the amount of debt they take on. The one with more debt will likely have a lower P/E value than the one with less debt. However, if business is good, the one with more debt stands to see higher earnings because of the risks it has taken.