What is the Price-to-Earnings Ratio?
Investors use the Price-to-Earning (P/E) ratio to measure the relationship of a company’s stock to its earnings per share of stock issued. Otherwise known as price multiple or the earnings multiple, P/E ratio enables investors to compare the company’s valuation to its peer group.
Investors use the P/E ratio to compare the performance of two companies or industries and to see which sectors are 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 you to compare a stock’s valuation to a benchmark such as the S&P 500 index.
Key Learning Points
- The price to earnings or P/E ratio is a key metric used in financial analysis which shows the relationship of a company’s share price to its earnings per share
- It is a widely used multiple but has its limitations as it is heavily affected by capital structure (care should be taken to compare with like for like companies)
- The diluted earnings per share (EPS) should always be used in the calculation as the share price already factors in the potential dilutive effect of options and other dilutive contracts
- The PE ratio of a company provides more context of the companies financial position when compared to a benchmark such as the S&P 500 index or comparable company
Price-to-Earnings Ratio
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
Company A and B reported the following at the end of year 1:
Company A Calculation:
Diluted EPS = $12 billion / 2 billion
= $6
P/E ratio = $80 / $6
= 13.3
Company B Calculation:
Diluted EPS = $12 billion / 3 billion
= $4 billion
P/E ratio = $70 billion / $4 billion
= 17.5
Points to Note
- According to the calculations, Company B has a higher rating since the share price represents a higher multiple of earnings per share
- Some of the possible reasons for Company B having a higher rating are better growth prospects for earnings per share, higher quality earnings, possible undervalue of shares and recovery prospects, and a higher return on internal investments
Analyzing the P/E Ratio
Investors will be willing to pay higher prices relative to profits for a number of different reasons:
- If they perceive that a company’s profits are more secure
- Market position in the market relative to competitors
- Management record
- Higher future growth rates
- Higher return on invested capital