What Is The Price Earnings Ratio?
The price/earnings ratio, often known as the P/E ratio, provides investors with information about a company's value. The stock price divided by the company's earnings per share over a specified period is known as the P/E ratio.
This ratio indicates the price an investor is willing to pay for each dollar of profit. Investors evaluate a company's price/earnings ratio before making an investment decision. To get the ratio, they compare the market value per share to the earnings per share.
New firms that require a lot of initial funding, such as tech start-ups, often have a high P/E ratio because investors are willing to pay more for a share of the company than the company is generating.
A decrease in the P/E ratio indicates slower growth, but it does not always spell doom for a business. It could indicate a firm that has successfully consolidated its market position.
When multiple companies in the same industry are compared over the same period, the price/earnings ratio provides valuable insight into market performance. For example, an investor might use this comparison to see if a firm is overvalued or undervalued.
Types of PE Ratios
Price to Earnings Ratio or Price to Earnings Multiple is the ratio of the share price of a stock to its earnings per share (EPS). One of the most widely used stock valuation metrics is the PE ratio. It indicates whether a stock is expensive or cheap at its current market price.
Let us look at the PE ratio, how it differs, and how it can be used to make investment decisions.
1) Shiller P/E Ratio
Investors can determine whether stocks are overvalued or undervalued using the Shiller P/E ratio, which also adjusts for short volatility. The most frequent application of this analytical tool is to assess the entire U.S. stock market.
Shiller P/E ratio = Current price / average inflation-adjusted 10-year EPS.
Low P/E ratios suggest a company might be a good value buy with the potential for high future returns, whereas high P/E ratios typically indicate an overvalued company.
2) Trailing Twelve Months (TTM) PE
A trailing P/E ratio is calculated using data from previous quarters. If no other qualifier is mentioned, this is the most typical interpretation of "P/E."
The term "trailing P/E from continuing operations" refers to earnings from continuing operations that exclude earnings from discontinued operations, extraordinary items, and accounting adjustments.
3) Forward P/E
A future P/E is the price/earnings ratio derived using anticipated net earnings for future quarters. Typically, estimates are calculated as the average of those released by a small number of analysts.
4) Price/earnings ratio example
On September 2, 2022,Apple'sstock ended the day at $159.57.Apple'searnings per share for the trailing 12 months is $6.05.
Price/earnings ratio = ($159.57 / $6.05) = 26.38
P/E Ratio Calculation
Given that the P/E ratio is the most often used indicator of how expensive a company is, it is crucial to comprehend the rationale and significance behind its pricing.
The two most significant factors that serve as the foundation for this appraisal are:
- Market value per share: The share's market price, or its worth on the open market, is what investors would pay to acquire one share of stock.
- Earnings per share: Earnings per share are calculated by dividing a company's annual revenue by the number of outstanding shares at the end of the year.
The price-earnings ratio can be calculated using the following formula:
Based on the formula above, let us calculate the price-earnings ratio.
If XYZ Ltd.'s market price per share is 200 rupees and its earnings per share are 30 rupees, the price-earning ratio will be as follows:
200/30 =6.67
This indicates that the stock's current market cap is 6.67 times its net profit.
Suppose there are two companies - X Ltd. (the tech industry) and Y Ltd. (the pharmaceutical industry) with price-earnings ratios of 4 and 5, respectively. Also, there is one more company Z Ltd. (belonging to the tech industry), with a price-earnings ratio of 4.5.
Since X Ltd. and Z Ltd. are in the same industry, the P/Es are comparable. Therefore, comparing the two with Y Ltd. is neither recommended nor possible because the findings would be inaccurate.
Price Earnings Ratio Analysis
The P/E is the current multiple at which the share is trading compared to its per-share earnings.
Only when comparing businesses in the same industry is this ratio meaningful. Therefore, such comparisons between businesses in other industries will produce false results and mislead investors.
Similarly, a business with a high PE ratio is frequently regarded as a growth stock. As a result, investors are typically willing to pay more for the shares of this company because this points to better profit growth and positive performance in the future.
A low PE can cause many variables; the company prospects may be on a decline, there might be a correction in the value, or it can be that the current P/E does not reflect the actual value of the business.
It is essential to understand why the P/E is what it is.
The most popular way of judging whether shares are appropriately valued about one another is the price/earnings ratio. However, the PE is not a standalone indicator of whether the share is a deal. Instead, the market's perception of risk and expected earnings growth determine the PER.
Pros and Cons of P/E Ratio
The financial health of a specific company is assessed by looking at its financial statements using ratio analysis tools. The price-to-earnings ratio (P/E) is one of many different types of ratios that are used.
The P/E ratio determines the relationship between a company's stock price and earnings. Let's first examine the benefits and drawbacks of the P/E ratio.
Pros
It is easy to calculate, the data is readily available, and the ratio applies to almost all types of profit-generating firms.
It can be used amongst large data sets to give a clear perspective on a relative basis.
Showcases business profitability and quality. Usually, high-quality businesses will have a higher P/E as a reflection of their growth and stability.
It is a dynamic ratio in that the earnings can be adjusted per the time frame of the trailing twelve months(ttm) or the last twelve months(LTM). The earnings can be normalized for cyclical stocks to get a more stable number.
Cons
The ratio does not account for the capital structure of the business.
P/E has the potential to deceive corporations through leverage. Atypical earnings might result from sporadic inflated profits from selling company assets. The P/E ratio becomes irrational as a result of these earnings.
Shares are undervalued in terms of their P/E during a recession. When there is inflation, the company's earnings are assessed using the local currency, which might raise the P/E. As a result, there are decent chances that the stock will be overvalued.
The PE ratio cannot be used by businesses losing money since it cannot account for losses during a company's early phases of expansion.
Evaluation of Stocks Using the P/E Ratio
An earnings report can provide information about the company's success but cannot explain how investors see its performance. The price-to-earnings ratio is one approach to assess this.
P/E can increase or decrease depending on the level of investor enthusiasm. Conversely, low investor enthusiasm might cause P/E to decrease. Stocks typically follow a pattern depending on external market factors as shown below:
- P/E expansion is when investors' attitudes change, and they become more willing to pay more for every dollar of earnings. P/E expansion describes a time when investors' perceptions are better, and they are willing to pay more for every dollar of earnings.
- P/E expansion is demonstrated, for instance, when the average P/E ratio for equities increases from 12 to 22 while total earnings are unchanged.
- When investors' opinions deteriorate and become less willing to pay a dollar's worth of earnings, this is known as P/E contraction.
- The most crucial factor to consider when investing is whether the shares of a particular company's current P/E is now high or low.
The problematic element is that arbitrary cutoff thresholds determine high and low. Therefore, the best method to evaluate a company's P/E is through:
I was comparing the current P/E with the company's historical P/E range. One of the quickest ways to determine whether a company is overvalued or undervalued is to calculate the P/E ratio of the stock.
Whenever possible, compare the company's current P/E to other businesses in a comparable industry.
In general, if the current P/E is at the lower end of a company's historical P/E range or if the company's current P/E is below the average P/E of similar companies, it may hint that the stock, despite the recent business performance, may be undervalued.
The P/E ratio can reveal how investors generally feel about a specific stock.
However, it is vital to compare the current P/E to prior P/E ratios and the P/E ratios of other firms in the same industry to determine whether a company is relatively overvalued or relatively cheap.
Similar to how unusually low or high P/E ratios might indicate possible opportunities or threats, stock prices can go to increasingly cheap or overpriced levels for a prolonged period before things turn around.
Absolute vs. Relative PE Ratio
An Absolute PE ratio serves as a metric to determine the overall price of a company’s shares compared to its current valuation. In contrast, a Relative PE ratio compares the company to a certain period or benchmark.
An absolute PE ratio is a ratio where the numerator is typically the current stock price, and the denominator is either the trailing EPS or the anticipated EPS for the upcoming 12 months.
It’s vital to remember that absolute PE represents the PE for the current period, while relative PE indicates how the PE compares to that of a different period.
Absolute P/E is the current price-to-earnings. Relative P/E compares that to a benchmark or past P/Es, say, over the past five years.
The relative P/E compares the absolute PE of the firm with a certain benchmark, be it the industry average, the market PE, or its own historical P/E.
The table below shows some differences in how each ratio is used compared to the other:
| Basis of difference | Absolute PE Ratio | Relative PE Ratio |
|---|---|---|
| Usage | Used to compare a company’s earnings to its present market value. | Used to compare a company’s earnings to a relative index, group of companies, or its’ own market value over a specified time. |
| Comparison | Can be used to compare the present value of a company to other similar businesses in an index or sector. | Can be used to compare the value of a business over a specific time to different time periods, or to similar businesses in a same or different time frame. |
| Measurement | Given in the form of a number, can be negative or an incredibly high number depending on the company and industry. | Given in the form of a percentage or decimal expressed in relation to another P/E ratio, depends on the company and relative industry. |
Absolute PE is calculated by dividing the current share price by the company’s earnings per share over the past 12 months.
For instance, the Absolute PE will be 20 ($40/$2) if the stock price is $40 today and the earnings per share are $2.
Absolute PE = Share Price of Firm / Earnings Per Share of Firm
Relative PE is calculated by determining a time frame and then dividing the PE of a company during that time in relation to a comparable company or sector.
Let's look at an example of relative PE calculation:
- Current PE: 27
- Historical PE: 30
- Relative PE: 0.90 (27/30)
Relative PE = PE of Firm / PE of Market or Comparable Company
Price to Earnings vs. Earnings Yield
The price-to-earnings multiple measures how much of a premium a company's stock currently trades at compared to its earnings. The relationship between a stock's share price and earnings is known as the P/E ratio. It aids in valuing a company for investors.
P/E Ratio = Market price per share / Earnings per share
Earnings Yield is the percentage representation of the reciprocal of Price-Earnings.
Earnings Yield = Earnings per share / Market price per share x 100
The earnings yield imagines the EPS as a coupon and the price as the face value of the bond. The higher the yield, the lower the valuation of the stock is.
By examining the earnings yield, the owners can determine whether the shares yield as much as other shares in the same industry. Some differences between the two terms can be found in the table below:
| Basis of difference | Price to Earnings (P/E) | Earnings Yield |
|---|---|---|
| Usage | Used to determine the value of a company relative to competitors or itself in a different time frame. | Used to determine a company’s earnings in a period of time relative to its’ share price. |
| Comparison | Used to determine a company’s present value compared to competitors or itself at different time frames. | Used to compare a company’s profitability with its’ valuation to determine if it is trading at a premium or a discount relative to competitors. |
| Measurement | Given in the form of a number, can be negative or a high number and varies depending on the company and industry. | Given in the form of a percentage, often used to compare stock yields with fixed income products such as treasuries and bonds. |
The earnings yield is a useful metric for investors when evaluating and choosing investments across various fixed investment options, not just stocks.
The P/E, on the other hand, identifies whether the stock is selling in the markets at a premium or discount price. P/E, then, indicates whether a stock is undervalued or overvalued.
Conclusion
The PE ratio is a great metric for stock and index valuation, but mutual fund managers also consider other factors when making investment decisions.
Those factors include assessing a sustainable business model, competitive advantage, market share and earnings growth potential, a low to average debt-to-equity ratio, and a strong management team.
A P/E ratio might be regarded as high or low, depending on the industry. For instance, companies in the healthcare sector have a higher P/E ratio than those in other sectors, such as apparel, air travel, etc.
Outside variables also influence the P/E ratio; a company is announced merger and acquisition will raise the P/E ratio. Therefore, before investing, it is essential to look at the company's history while considering all of its stakeholders.
