Price to Earnings (P/E) Ratio Formula and Definition

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Price to Earnings (P/E) Ratio Formula and Definition

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The Price to Earnings Ratio, also known as the P/E ratio or the Earnings Multiple ratio, is used extensively amongst seasoned and new investors to quickly value companies by investors and analysts. It highlights the the price of a company, for each dollar of its earnings. The valuation multiple is often used to value companies with their peers, or against their prior own valuation levels.

Formula for Price to Earnings (P/E) Ratio

To calculate the Price to Earnings ratio, we simply need to divide the company’s current stock price by earnings per share or EPS.

The formula for calculating the P/E ratio is:

Price to Earnings ratio = Market value per share/Earning per share

or,

Price to Earnings ratio = Market capitalization / Total Net Income

For example, the EPS of Nestle at some point was $2, and the market price of the share was $20, so the P/E would be calculated as $20/2=$10. In other words, the company was trading at 10 times its earnings.

Uses of the Price to Earnings (P/E) Ratio 

  • It is used to measure a company’s current stock price to its earnings per share or EPS, i.e., its earnings, thus denoting a relationship between them. The ratio shows the expectations of the market.
  • P/E ratio is most commonly used to compare records of a company over different periods to compare the aggregate markets over time or against one another as it standardizes the stocks of various prices and earning levels.
  • The Price to Earnings ratio helps the investor determine if he is paying a fair price.

Interpretation of the P/E Ratio

A higher P/E depicts a higher price of the stock compared to its earnings, thus overvaluation of a company’s stock, while a lower P/E depicts undervaluation. When a company has a higher P/E ratio, investors may also expect high growth rates in the future, which means that the company will grow faster than the average, as for the example of technology companies. A higher Price to Earnings ratio indicates a higher share price being offered today by the investors in expectations for higher growth in the future.

P/E ratio is absent in companies that are either losing money or have no earnings. In determining how profitable a company is or will be, earnings are an important factor seen by the investors. In case the growth of the company and the current level of earnings get stagnant, the P/E ratio becomes the number of years it takes for the company to pay back the amount that has been paid for each share.

A P/E ratio is required to be calculated against the average P/E for the company’s industry. 13 to 15 is the average range of P/E ratio for the S&P 500. For instance, A company with a current P/E ratio of 30 above the S&P average, trades at 25 times earnings.

It can be estimated on both forward and backward basis denoted as projected and trailing respectively:

  1. Forward Price to Earnings ratio.
  2. Trailing Price to Earnings ratio

Forward Price to Earnings:

The forward P/E ratio, also known as the leading P/E ratio or estimated price to earnings ratio, uses future earnings guidance for comparing current earnings to future earnings, thus depicting a clear picture of earnings excluding changes and adjustments. With the forward P/E ratio, the problem is that the company underestimates earnings to beat the estimated P/E when the announcement for the next quarter’s earnings is made. The earnings can sometimes be overestimated and then get adjusted later while going into the earnings announcement. It might further create chaos as external analysts might provide estimates that differ from the company’s estimation.

Trailing Price to Earnings:

The trailing P/E depends entirely on the past performance of the last 12 months. It is defined as the most objective metric. The limitation of trailing P/E is that the measure based on past performance may not accurately determine future behavior. Thus, investors often prefer to commit money based on future earnings rather than the past. The constant fluctuation of the share prices, while the EPS remains the same, becomes more problematic as the trailing P/E ratio does not reflect much the changes in significantly higher or lower stock prices. The calculation for earnings is made every quarter while the stocks trade day in and day out, which results in the continuously changing trailing ratio, making the investors prefer the forward P/E ratio over the trailing P/E ratio. Analysts expect the earnings to increase when the forward P/E ratio is lower than the trailing P/E ratio and expect to decrease when forward P/E is higher than the current P/E ratio.

The P/E ratio can further be divided into two more types of ratios that helps in indicating the performance of a company:

  1. Absolute price to earnings ratio: The traditional Price to earnings ratio is determined by dividing the current stock price of a company by either past or future earnings of the company.
  2. Relative price to earnings ratio: While calculating the relative price to earnings ratio, comparing the absolute P/E ratio against the benchmark P/E ratio is done for the respective companies.

Limitations of using the Price to Earnings (P/E) ratio: 

  • Determining an accurate earnings number is challenging. The P/E ratio is calculated by measuring the trailing earnings. But since the historical earnings reveal very few details about the future earnings, which is the more important figure, the investors are not much interested in it.
  • If the market prices are volatile, the determination of the P/E ratio in the short term can be affected.
  • While estimating the forward or future earnings, analysts can sometimes be over-optimistic during economic expansion and pessimistic during economic contraction.
  • The concept of earnings growth is not included in the P/E ratio. In case the growth of the company is quick and high, an investor prefers buying it at a high P/E ratio expecting earnings growth to bring the P/E down to a lower level. The investor looks elsewhere for a stock with a low P/E ratio if the earnings are not growing quickly. So, it gets difficult to determine if the high P/E ratio is due to overvaluation or a result of expected growth.

Concept of a good Price to Earnings (P/E) ratio

The question of a good or a safe P/E ratio always has puzzled investors. The concept of a good P/E ratio depends on various factors like current market conditions, the nature of the industry, etc. Thus, the P/E ratio is used as a measure of comparison of performance between companies of the same industry or same characteristics, same growth phase, etc. On the one hand, the risk of value trap investments is associated with high ratios, while on the other, lower ratios denote the subpar performance of a company owing to its internal faults. Thus, the concept of a good or safe P/E ratio is not much useful, relying on which investors can make decisions in the stock market. In this aspect, other factors like discounted cash flow, the weighted average cost of capital, etc., can be used to calculate a company’s profitability.

Conclusion

The Price to Earnings ratio (P/E ratio) is one of the most common measures that aid investors in determining if a company’s stock price is valued fairly with respect to its earnings. Despite its several limitations that are advised to be considered while computing a stock’s valuation, the P/E ratio is quite convenient to use.

It doesn’t provide much insight into a stock’s valuation since the P/E ratio does not include the effects of future earnings growth. But using a single ratio cannot possibly tell the investors all the details about a stock, so they need to use different ratios to paint the complete picture of a company’s finances and stock valuation. The high or low factor of a P/E ratio depends on the industry type along with various external factors. A higher Price to Earnings ratio is usually found in IT and telecom companies, while manufacturing, textile, etc., industries have lower ratios. An example of an external factor that is responsible for an increase in the P/E ratio would be merger and acquisition. So, all factors and ratios should be examined before investing.

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