What Is the PE Ratio?
The PE ratio (price-to-earnings ratio) or earnings multiple is one of the most popuar metrics for stock valuation. You can calculate it by dividing a company’s stock price by its earnings per share (EPS). It shows the amount of money investors are willing to pay for $1 of a company’s earnings.
A high PE ratio indicates that investors pay much more per share than the company’s earnings warrant. This could indicate that the stock is overvalued, and investors should not buy it. However, for fast-growing companies such as tech start-ups, it could also indicate that investors expect high growth rates in the future and could be a good investment.
A low price-earnings ratio often indicates that the stock is undervalued, which is good for value investors who are always looking for a bargain. But, on the flip side, it could also mean that investors are factoring in warning signs that indicate lower earnings or other problems in the future.
When comparing PE ratios of different companies, it is important to compare similar companies within the same industry, as PE ratios vary from industry to industry.
The PE also can also help gauge the stock market as a whole and reveal how a stock’s valuation compares to its industry group or a benchmark like the S&P 500 index.
Price-Earnings Ratio Formula and Calculation
You can calculate the price-to-earnings ratio by dividing a company’s current stock price (market value) by its earnings per share (EPS).
Market Value of Share (current share price): The market price of a share is the price that the market is willing to pay for a company’s stock at a given moment in time. Many financial websites publish current share prices. However, the market price reflects the current market sentiments and therefore, the market price can fluctuate based on factors such as
- Public sentiments
- Macroeconomic indicators
- Financial fundamentals of the relevant company
Earnings per Share: Earnings per share (EPS) is a ratio published in the company’s financial statements. The ratio gives insight into a company’s financial health.
Earnings per share = (net income – preferred dividends) / # common stocks)
You can calculate a company’s EPS by taking a company’s net income and subtracting its preferred dividends. Then divide the result by the number of outstanding common stocks. Investors consider a high EPS a good indicator of a company’s profitability, whereas a low EPS shows that a company’s profits might be on the low side.
Companies that are losing money or have no earnings do not have a P/E ratio.
There are different types of EPS,’ which adds complexity to EPS itself and the PE ratio. For example, there is a simple or trailing EPS that shows historical EPS, and there is a projected EPS, which is a forecast of the company’s EPS based on current projections of future earnings. This means that the type of EPS used in the PE ratio will affect the PE ratio.
Trailing PE versus Forward PE
There are several different versions of PEs dependent on the version of EPS used in the calculation. The 2 most popular types are the trailing PE and the forward PE. When analyzing a company’s value and its stock value, it is important to know which price-earnings ratio has been used before making an investment decision. It might even be a good idea to use both types of PEs.
The trailing one is the more popular one. It is based on history and actual performance statistics, while the forward price to earnings ratio is based on the future and performance expectations.
The Trailing PE is calculated by dividing the current share price by EPS (earnings per share) over the past 12 months. When looking up this ratio in financial reports, it is written as TTM, which means “Trailing Twelve Months,” representing a company’s financial performance from the last 12 consecutive months.
The trailing PE is considered the most reliable and objective indicator of a company’s value and profitability because it is based on historical financial data that has been audited and officially reported.
Although considered objective, the trailing price-earnings ratio has two main limitations.
The first limitation is that it is based on the market value of shares. Current stock prices fluctuate daily, which can make the trailing PE unreliable in certain instances. For example, stock prices are partially driven by emotions triggered by rumors and expectations about major economic developments or the company. Often this results in an erratic increase or decrease in the stock price, which will result in a price-earnings ratio that is out of wack in the short term but will stabilize again when common sense returns to the market.
The second drawback of the trailing ratio is that it is based on past earnings. Unfortunately, past earnings are no guarantee for future expectations. When it comes to investment decisions, investors need a more long-term, forward-looking indicator to base their investment decisions on.
The forward PE is calculated by dividing the current share price by its “predicted” EPS (earnings per share) for the next 12 months.
The forward price-earnings ratio also called the estimated price to earnings. It is based on projected EPS and is published by companies as investors need a company’s future projections to make informed investment decisions.
The forward PE ratio does have its drawbacks. It is a subjective financial metric, and it may vary depending on who has calculated the projection for future earnings. There is room for companies to indulge in creative accounting and deflate the projected earnings. When the next quarterly results come out, they overshoot the projected earnings, thus engineering a feel-good factor about the company’s financial performance.
One way to overcome this bias is to use the projected earnings figures prepared by an objective and impartial financial analyst.
How to Use the PE Ratio to Value a Company and Its Stocks?
PE is a much better comparison of the value of a stock than the share price. The price-earnings ratio show how much value the market places on a company’s stock relative to its actual earning potential.
Example: A $20 stock with a PE of 40 is much more valuable than a $100 stock with a PE of 8. Although the $100 share has a higher absolute value, you pay relatively more for the $20 stock. The market is willing to pay 40 times for every $1 of current earnings expected. The market is willing to do this as the market believes that the future earnings stream is worth it. The $20 stock is probably from a small company with an exciting product in a growth industry with few competitors. The $100 stock is probably from a large company in a slow-growth industry.
The PE ratio measures how much investors are willing to pay for a company’s earnings. Generally speaking, the higher the PE ratio, the more investors are willing to pay for a dollar’s worth of a company’s earnings.
What is considered a high PE and a low PE for evaluating a company’s share price? This is a difficult question to answer. Besides common sense, several other factors influence the PE and need analyzing to answer that question.
First, the price-earnings ratio should be somewhat comparable to that company’s growth rate. If the ratio is much higher than the growth rate, the share price is high compared to history. In contrast, if it is much lower, then the share price is low compared to history.
The second factor to consider is the forward and historical earnings growth rate. For example, if a company has been growing at about 15% per year over the past 10 years but has a PE ratio of 65, it would most likely mean that the shares are costly.
Finally, when evaluating a company’s share price, it is essential to consider the industry’s PE. Different industries have different price-earnings value ranges that are considered normal for that particular industry. For example, technology companies usually sell at larger price-earnings ratios because they havemuch higher growth rates and earn higher equity returns. In contrast, companies in the energy sector traditionally have a lot lower PEs. Exceptions may arise during a recession or an economic boom. During these events, the “normal” PE range for an industry sector might shift down or up.
What Is the PEG Ratio?
The price-to-earnings ratio is one of the most widely used metrics when valuing stocks. However, it does not take a company’s growth rate into account. Even the forward PE has its limitations as it does not tell investors much about the EPS growth prospects. It is difficult to tell if a high PE results from high expected growth or if the stock is overvalued.
The PEG (Price Earnings Growth ) ratio measures the relationship between the price-earnings ratio and earnings growth. You can calculate it by taking a company’s PE ratio and dividing it by its earnings growth rate for a specified period.
The PEG shows investors whether a stock’s price is overvalued or undervalued. It analyzes both today’s earnings and the expected growth rate for the company.
The PE ratio used in the calculation may be projected or trailing. The EPS growth rate may be the expected growth rate for the next year or the next five years.
Typically, A PEG ratio of less than 1 can indicate an undervalued stock. In contrast, a PEG ratio of more than 1 can indicate that a stock is overvalued and too expensive. However, to value a stock, the PEG ratio is only one piece of the puzzle. Remember, different industries have different average PEG ratios.
Price-Earnings Ratio versus PB Ratio
The price-earnings ratio is also at times compared with the price-to-book value ratio. The price to book value ratio equals the market value of the shares (share price) divided by the book value per share.
While the PE ratio shows the market value relative to its profitability, the price-to-book value ratio shows the market value relative to the value of a company’s net assets per share. Thus, it can be used to value firms with positive book values and negative earnings as some companies and industries are more efficient at producing income from their assets than others.
Absolute versus Relative Price-Earnings
The absolute ratio is the trailing PE ratio. Analysts sometimes compare it with the company’s past PE ratios to see how it is currently faring. This is an internal comparison of a company with its past performance.
For external comparison, the absolute price-to-earnings ratio of a company is compared against the industry’s benchmark PE ratio to determine how the company is performing relative to the industry. It is important to note that each sector and each industry has a different PE ratio that serves as a benchmark ratio. A PE ratio can, therefore, be compared with the following benchmarks.
- Past PE ratio of the company
- Price-earnings ratios of competitors
- PE ratios of similar companies
- Price-earnings ratios of the industry
Limitations of Price-Earnings Ratio
Although the PE ratio is a commonly used ratio to value a company, it has some limitations. These are the most common limitations:
- Based on past performance – Trailing price-earnings is based on past performance, which does not accurately predict a company’s future performance.
- May be biased – Forward price-earnings may be biased and is often not objective. The value of the ratio often differs depending on who prepared it.
- Use of creative accounting – Companies may use creative accounting to deflate the forward EPS to make actual future earnings and performance look more attractive.
- Stock price is volatile – Market value (current stock price) is a volatile measure of value. It fluctuates daily and is often driven by emotions. This can result in a PE that is out of whack in the short term. Consider looking at the ratio over a longer period.
- It includes extraordinary events – The earnings figure used includes extraordinary events that may occur, which may offset the final figure. This may result in the PE being higher or lower than it should be.
- Debt is not considered – The amount of debt is not taken into consideration. A company with a large proportion of debt to total value is riskier than a company with no debt.
The PE ratio is the most widely used metric for valuing a company and is easy to calculate. However, it should not be used independently. It just one piece of the puzzle to a company’s financial health and stock valuation. Analyses of a variety of other ratios and metrics are necessary before investors should take action.