What is the 'Price-Earnings Ratio - P/E Ratio'
The price-earnings ratio can be calculated as:
Market Value per Share / Earnings per Share
For example, suppose that a company is currently trading at $43 a share and its earnings over the last 12 months were $1.95 per share. The P/E ratio for the stock could then be calculated as 43/1.95, or 22.05.
EPS is most often derived from the last four quarters. This form of the price-earnings ratio is called trailing P/E, which may be calculated by subtracting a company’s share value at the beginning of the 12-month period from its value at the period’s end, adjusting for stock splits if there have been any. Sometimes, price-earnings can also be taken from analysts’ estimates of earnings expected during the next four quarters. This form of price-earnings is also called projected or forward P/E. A third, less common variation uses the sum of the last two actual quarters and the estimates of the next two quarters.
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BREAKING DOWN 'Price-Earnings Ratio - P/E Ratio'
In essence, the price-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings. This is why the P/E is sometimes referred to as the multiple because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends. When a company has no earnings or is posting losses, in both cases P/E will be expressed as “N/A.” Though it is possible to calculate a negative P/E, this is not the common convention.
The price-earnings ratio can also be seen as a means of standardizing the value of one dollar of earnings throughout the stock market. In theory, by taking the median of P/E ratios over a period of several years, one could formulate something of a standardized P/E ratio, which could then be seen as a benchmark and used to indicate whether or not a stock is worth buying.
Limitations of 'Price-Earnings Ratio - P/E Ratio'
Like any other metric designed to inform investors as to whether or not a stock is worth buying, the price-earnings ratio comes with a few important limitations that are important to take into account, as investors may often be led to believe that there is one single metric that will provide complete insight into an investment decision, which is virtually never the case.
One primary limitation of using P/E ratios emerges when comparing P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due both to the differing ways companies earn money and to the differing timelines during which companies earn that money. As such, one should only use P/E as a comparative tool when considering companies within the same sector, as this kind of comparison is the only kind that will yield productive insight. Comparing the P/E ratios of a telecommunications company and an energy company, for example, may lead one to believe that one is clearly the superior investment, but this is not a reliable assumption.
An individual company’s P/E ratio is much more meaningful when taken alongside P/E ratios of other companies within the same sector. For example, an energy company may have a high P/E ratio, but this may reflect a trend within the sector rather than one merely within the individual company. An individual company’s high P/E ratio, for example, would be less cause for concern when the entire sector has high P/E ratios.
Moreover, because a company’s debt can affect both the prices of shares and the company’s earnings, leverage can skew P/E ratios as well. For example, suppose there are two similar companies that differ primarily in the amount of debt they take on. The one with more debt will likely have a lower P/E value than the one with less debt. However, if business is good, the one with more debt stands to see higher earnings because of the risks it has taken.
Another important limitation of price-earnings ratios is one that lies within the formula for calculating P/E itself. Accurate and unbiased presentations of P/E ratios rely on accurate inputs of the market value of shares and of accurate earnings per share estimates. While the market determines the value of shares and, as such, that information is available from a wide variety of reliable sources, this is less so for earnings, which are often reported by companies themselves and thus are more easily manipulated. Since earnings are an important input in calculating P/E, adjusting them can affect P/E as well. (See also, How can the P/E ratio mislead investors?)
Things to Remember
- Generally a high P/E ratio means that investors are anticipating higher growth in the future.
- The average market P/E ratio is 20-25 times earnings.
- The P/E ratio can use estimated earnings to get the forward looking P/E ratio.
- Companies that are losing money do not have a P/E ratio.
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