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