Price to Earnings Ratio (P/E Ratio)

What is the Price-to-Earnings Ratio?

Investors use the Price-to-Earnings (P/E) ratio to measure the relationship of a company’s stock price to its earnings per share of stock issued. Also known as the price multiple or the earnings multiple, P/E ratio enables investors to compare a company’s valuation to its peer group and its prior (and expected future) performance.

Investors use the P/E ratio as a valuation metric to compare the performance of two companies or industries to see which is over or underpriced. The P/E ratio provides an insight into the potential growth and returns of a company’s stock and indicates how much investors are prepared to pay for every dollar of earnings.

Besides showing if a company’s stock is under or overvalued, the P/E ratio also allows investors to compare a stock’s valuation to a benchmark such as the S&P 500 index.

Price-to-Earnings Ratio Formula

To calculate the P/E ratio, divide the company’s stock price by its earnings per share (EPS) (usually the market uses diluted earnings per share).

P/E ratio = Stock price / EPS

It can also be calculated by taking the company market cap (equity value) and dividing it by the net income for the period.

P/E ratio = Market cap / Net income

P/E Ratio Formula Explanation

Listed companies will have plenty of share price information available so it should be relatively straightforward to find these two pieces of information.

• Market Price per Share: The current trading price of the company’s stock
• Earnings per Share (EPS): The company’s net earnings divided by the number of outstanding shares

If a company is privately held and does not disclose much share price information, analysts could calculate this by taking the total market value and the total net income for the company. This is helpful for listed companies if there is not much up-to-date information available on the share count for the period.

P/E Ratio Example

Let’s look at an example of how to calculate the P/E ratio for two companies.

Company A and B reported the following information at the end of year 1:

Using this information, we can work out the PE ratio of each company.

Company A Calculation:

• Calculated the diluted EPS using the net profit and the diluted number of shares outstanding: $12 billion / 2 billion = $6
• Take the stock price and divide it by the diluted EPS: $80 / $6 = 13.3x

The PE for Company A is 13.3x for the year 1 period.

Company B Calculation:

We need to take the same steps for the Company B calculation

• Calculate the diluted EPS
• Diluted EPS = $12 billion / 3 billion = $4 billion

Calculate the P/E ratio

P/E ratio = $70 billion / $4 billion = 17.5x

The PE for Company B is 17.5x for the year 1 period.

These two ratios can now be compared, and we can say that Company B is trading on a higher PE than company A.

Given Company A is trading on a lower PE than company B this may suggest that Company A is a better investment opportunity at the stage as its PE ratio is lower.

Download the free Financial Edge P/E ratio template and follow these steps in excel to complete the calculations.

Points to Note

According to the calculations, Company B has a higher PE ratio since the share price represents a higher multiple of earnings per share.

Some of the possible reasons for Company B having a higher rating include better earnings growth prospects, higher quality earnings, possible undervalue of shares and recovery prospects, and a higher return on internal investments. What analysts will be looking for is an indication that the company is valued appropriately for the current market conditions.

Analyzing the P/E Ratio

In theory investors who are seeking value investments should buy companies with a low PE ratio as the stock prices may be low for a number of short-term reasons and then rise to the same P/E ratio as the peer group.

Investors will be willing to pay higher prices in relation to profits for a number of different reasons:

• If they perceive that a company’s profits are more secure
• The company has a stronger market position relative to competitors
• Management has a strong track record for leadership
• The company is expected to have higher future growth rates
• The company offers a higher return on invested capital

P/E Ratio in Use

The Price-to-Earnings (P/E) ratio is a widely used metric to evaluate the valuation of a company’s stock. It helps investors determine if a stock is overvalued, undervalued, or fairly valued compared to its earnings.

There are several ways to use the P/E ratio:

Compare the Company’s PE Ratio to Future or Previous Performance

If a company is growing it will typically have a lower P/E ratio for future years (as the stock price remains today but the earnings will grow e.g. 8% in year 2 so the ratio will fall. Thus, if a company is trading on 16.2x today, and 14.3x for next year we could assume that the stock price will rise until the ratio is back at 16.2x if that is the average P/E for the company.

Also, if a company is continuing to grow earnings in line with previous years but its P/E ratio has moved from 18.5x to 16.2x then this may suggest the stock is undervalued. Analysts would need to gauge market conditions and other factors when assessing this.

Compare a Company to its Sector

A sector P/E can be created by taking the average of the P/E ratios in the group and then comparing it to a company. If the company’s P/E ratio is lower, then we can assume that this may be a buying opportunity for that stock. However, before investors decide this, they will look to see if the company has typically traded on a discount or premium to the sector in the past. If it is the former, then this may not represent a buying opportunity.

Compare a Company to a Peer Company

Companies can be compared using the P/E ratio, but it is important to make sure the same period is being compared (particularly if fiscal year ends are different) and also to ensure that the companies are similar enough in product and growth prospects to compare.

What Other Factors Impact a Price Earnings Ratio?

We cannot look at the price earnings ratio without considering the ‘quality’ of earnings at a company. Two companies may trade at the same P/E ratio, say 15.5x, but have a very different profile.

Different Industry P/E Ratios

Firstly, two companies might be from different sectors – tech stocks typically trade on much higher P/E ratios than asset intensive, or low growth sectors. Analysts need to consider a company P/E ratio in the context of the specific sector.

Different Company Life Stages

Secondly, the companies might be at different life stages – one may be a mature company with low growth prospects but generating cash flow, and the other may be a new company still gaining market share and investing to grow earnings. Investors need to be clear in what their expectations are for earnings growth when looking at the P/E ratios.

Higher Quality Earnings

Investors typically seek companies with reliable earnings, either robust or growing annually. They also are prepared to ‘pay more’ in terms of a higher P/E ratio if a company has a strong market presence (such as the market leader in a product or service) or has a global presence.

Historical Performance

It is important to also consider the historical P/E of a company – if a company is trading at a lower P/E ratio than it has done in the past this will warrant further analysis. There could be a market anomaly, so the stock price has temporarily fallen. Or there could be a longer-term issue with earnings, and perhaps growth is slowing, or the company has lost its leadership position in a market.

Conversely if the company is trading on a higher P/E ratio than in the past, this may be due to a strong stock market performance (perhaps aided by macro conditions) or an improvement in earnings quality. A stock can justify a higher P/E when its performance improves.

Why Use the Price Earnings Ratio?

The P/E ratio is used because it provides a quick snapshot of a company’s valuation relative to its earnings. It helps investors compare the valuation of different companies, even if they operate in different industries.

Justified P/E Ratio

The justified P/E ratio is a theoretical value that considers the company’s growth rate, dividend payout ratio, and required rate of return.

It is calculated using the formula:

Justified P/E ratio = (( DPS / EPS) * (1 + g)) / (k – g)

Justified P/E Ratio = ((DPS/EPS) x (1+g)) / (k-g)

Where:

DPS is dividend per share

EPS is earnings per share

g is the expected growth rate

k is the required rate of return

This variation is an extension to try and better understand the company’s fundamental valuation by taking dividend payments as well as growth rates into account.

Limitations of Price Earnings Ratio

The P/E ratio is a widely used metric, but it has its limitations:

• Earnings Manipulation: companies can manipulate earnings, affecting the P/E ratio
• Growth Rates: the P/E ratio does not account for future growth rates, just the period being measured
• Industry Differences: different industries have different average P/E ratios, making cross-industry comparisons challenging
• One-Dimensional: it only considers earnings and not other factors like debt, cash flow, or market conditions

Conclusion

The Price to Earnings (P/E) Ratio is a crucial metric for investors to evaluate the value of a company’s stock. By comparing the current share price to its earnings per share, investors can gain insights into market expectations and make informed decisions. Understanding the P/E Ratio helps in identifying potential investment opportunities and assessing the financial health of a company. Keep this metric in mind as you navigate the complexities of the stock market.

Additional Resources

Net Present Value (NPV)