DEFINITION of Price-Earnings Relative
Price-earnings relative refers to the price-earnings ratio of a stock divided by the price-earnings ratio of a broader market measure. The price-earnings ratio, often written as P/E, is equal to a stock's or broad market's market price divided by a measure of the stock's or market's earnings. There are many methods for measuring the earnings figure used in the denominator of the formula, though practitioners usually use a measure of forward earnings, meaning earnings forecasts, or trailing earnings, meaning actual reported earnings, over a 12-month period. The price-earnings relative measure is meant to give a determination of the relative over- or undervaluation of a company relative to its industry, financial sector, the broad market or some other broad peer group.
How Do I Calculate the Price-Earnings Ratio?
BREAKING DOWN Price-Earnings Relative
The price-earnings relative value is a method for judging whether a price-earnings ratio is reasonable in relation to market conditions. A price-earnings relative value of less than 1 indicates that a stock has a lower P/E ratio than its broader peer group. A price-earnings relative value of 1 indicates that a stock has the same P/E ratio as its peer group. A price-earnings relative value of greater than 1 indicates that a stock has a higher P/E than its peer group. For example, as of May 25, 2018, Apple Inc. (AAPL) had a P/E ratio of 18.2, while the S&P 500 had a P/E ratio of 20.6. The price-earnings relative value for AAPL is 0.88.
Interpreting the Price-Earnings Relative Value
The P/E ratio is often referred to when determining whether a stock represents a buying opportunity or not. At a basic level, a P/E value lower than the peer group and a corresponding price-earnings relative value of less than 1 may be an indication that the stock is trading cheaply, representing a good time to buy. The rationale for this conclusion is that a lower P/E indicates that each dollar of earnings costs less for this stock than for the average stock in the peer group. The reverse is true if the P/E for the stock is greater than that of the peer group and the price-earnings relative value is greater then 1, which may be an indication that the stock's earnings are more expensive than the average stock in the peer group.
It is worth noting, however, that the P/E ratio and price-earnings relative value are only one piece of a large mosaic of data that should be used to form an opinion on a stock. A low price-earnings relative value may indicate that the company is in dire financial straits, and not necessarily a good buy. Conversely, a high price-earnings relative value may indicate that the firm has much better growth prospects and may be worth a higher price. Price-earnings relative values are a starting point for fundamental evaluation.