The simple answer to this question is that absolute P/E, which is the most quoted of the two ratios, is the price of a stock divided by the company's earnings per share (EPS). This measure indicates how much investors are willing to pay per dollar of earnings. The relative P/E ratio, on the other hand, is a measure that compares the current P/E ratio to the past P/E ratios of the company or to the current P/E ratio of a benchmark. Let's look at both absolute and relative P/E in more detail.
Absolute P/E The nominator of this ratio is usually the current stock price, and the denominator may be the trailing EPS (from the trailing 12 months [TTM]), the estimated EPS for the next 12 months (forward P/E) or a mix of the trailing EPS of the last two quarters and the forward P/E for the next two quarters. When distinguishing absolute P/E from relative P/E, it is important to remember that absolute P/E represents the P/E of the current time period.
For example, if the price of the stock today is $100, and the TTM earnings are $2 per share, the P/E is 50 ($100/$2).
Relative P/E Relative P/E compares the current absolute P/E to a benchmark or a range of past P/Es over a relevant time period, such as the last 10 years. Relative P/E shows what portion or percentage of the past P/Es the current P/E has reached. Relative P/E usually compares the current P/E value to the highest value of the range, but investors might also compare the current P/E to the bottom side of the range, measuring how close the current P/E is to the historic low. The relative P/E will have a value below 100% if the current P/E is lower than the past value (whether the past high or low). If the relative P/E measure is 100% or more, this tells investors that the current P/E has reached or surpassed the past value.
Suppose a company's P/Es over the last 10 years have ranged between 15 and 40. If the current P/E ratio is 25, the relative P/E comparing the current P/E to the highest value of this past range is 0.625 (25/40), and the current P/E relative to the low end of the range is 1.67 (25/15). These value tell investors that the company's P/E is currently 62.5% of the 10-year high, and 67% higher than the 10-year low.
If all is equal over the time period, the closer the P/E gets to the high side of the range and further away from the low side, the more caution an investor needs since this could mean the stock is overvalued. There is, however, a lot of discretion that goes into interpreting relative P/E. Fundamental shifts in the company such as an acquisition of a highly profitable entity can justifiably increase the P/E above the historic high.
As we mentioned above, relative P/E may also compare the current P/E to the average P/E of a benchmark such as the S&P 500. Continuing with the example above where we have a current P/E ratio of 25, suppose the P/E of the market is 20. The relative P/E of the company to the index is therefore 1.25 (25/20). This shows investors that the company has a higher P/E relative to the index, indicating that the company's earnings are more expensive than that of the index. A higher P/E, however, does not mean it is a bad investment. On the contrary, it may mean the company's earnings are growing faster than those represented by the index. If, however, there is a large discrepancy between the P/E of the company and the P/E of the index, investors may want to do additional research into the discrepancy.
Absolute P/E, compared to relative P/E, is the most-often used measure and is useful in investment decision making; however, it is often wise to expand the application of that measure with the relative P/E measure to gain further information.
For more information on the price to earnings ratio please read Understanding the P/E Ratio tutorial.
Backwardation is a market condition in which a futures contract far from its delivery date is trading at a lower price than ...
Investors have long praised Warren Buffett’s ability to pick great companies to invest in. Lauded for consistently following ...
Find out how to calculate this common valuation ratio and what the results can tell you about a company's performance.
A low P/E ratio doesn't automatically mean a stock is undervalued, just like a high P/E ratio doesn't necessarily mean it ...
The amount of net income returned as a percentage of shareholders ...
A trading strategy in which an investor buys a long position ...
A standard agreement used in over-the-counter derivatives transactions.
A ratio of a company’s cash flow from operations to its total ...
A valuation measure, generally applied to broad equity indices, ...
A term coined by portfolio manager John Schwinghamer to describe ...