The Price to Earnings Ratio (P/E) is a way of comparing the price you’d pay for one dollar in earnings. It’s an essential measure because investors and analysts use it to gauge how much shareholder value one company can generate relative to its current share price.
You may be wondering how the P/E ratio impacts you and your investments.
This article shares my perspective on what a stock’s price-to-earnings (P/E) ratio means for investors, why it is essential to pay attention to this metric, as well as things to consider when investing in stocks.
What is the Price to Earnings ratio?
The P/E ratio is a metric used to measure the worth of a company relative to its net earnings. It is calculated by dividing the price per share of stock by earnings per share and multiplying it by 100.
A company’s P/E ratio can be misleading when investors look at one company and compare it to another without considering other factors that could impact its potential success or failure, such as industry competition or market demand. The idea is that you should not compare the reported P/E number with the earnings of a different company to determine how well their stock will perform in future years.
It can be calculated by dividing the current market value of a company by total equity, or you can also find it on an individual share basis. It could help investors determine whether they should buy more shares in that particular companies’ stock.
P/E ratio in use
The price-to-earnings ratio is a standard metric used in stock market analysis to compare the “value” of companies. In other words, it’s the number of shares that you can buy for every dollar earned by an individual company during a given period.
The P/E ratio is a stock market measurement for the price of one share relative to its earnings per share. It’s a significant number because it consistently standardizes stocks. For example, if the P/E stands at 10, then $10 will buy one share and earn you 10% of the company’s annual profits.
This ratio can be misleading because it’s not compared to historical P/E or even competitor P/Es in the same industry. For investors and analysts to properly compare companies on an apples-to-apples basis, they need these other metrics when making predictions about future performance and valuations.
This ratio is calculated using two critical inputs: current share price and earnings per share (EPS). The P/E will likely be higher if EPS growth has been substantial or recently exceeded expectations; on the other hand, there will be a lower P/E if EPS has been declining.
A low P/E is often interpreted as indicating that the stock price is below fair value, while a high one suggests it’s above.
The formula for calculating the P/E ratio
The P/E ratio is calculated by dividing the stock price, or market capitalization, by earnings per share. The annual earnings are needed to calculate the P/E ratio.
The exact formula is:
P/E ratio example
Therefore, if a hypothetical firm named Always Profit presently trades at $100 per share and earns $25 per share of stock over the next 12 months, AP’s P/E ratio is 100/25, or 4x. This signifies that the price of AP stock is four times the company’s yearly earnings per share.
Another way to think about a company’s P/E ratio is buyers’ price for one dollar of annual earnings. According to the scenario above, a novice investor may anticipate earning $1 per year on every $4 invested in AP. If Stock A is listed at $30 while Stock B is trading at $20, it is not obligatory that Stock A is more costly. The P/E ratio can assist us in determining which one of the two is more affordable from a value standpoint.
If the sector’s average P/E is 15 and Stock A has a P/E of 15, and Stock B has a P/E of 30, Stock A is less expensive than Stock B, although having a greater actual price, since you pay less for each dollar of current profits. On the other hand, Stock B has a greater ratio than its rival and the sector.
This might imply that investors anticipate future profits growth to be faster than the market. The P/E ratio is one of several valuation metrics and financial analysis tools that we utilize to aid in our investment decision-making, and it should not be the only one.
Limitations of P/E ratio
The P/E ratio is not a set rule, and it isn’t the best valuation measure. For instance, if an investor buys a stock with no debt or tax liabilities, their net profit won’t be included in the earnings per share. Moreover, suppose a company does not disclose their profit margin or doesn’t have one because they are involved in an industry that is constantly changing. In that case, the P/E ratio will not give investors a complete picture of how much value their stock has.
Moreover, the P/E ratio will be different in periods of recession and growth and depending on what each company is doing. The number can help determine if a stock is worth purchasing or not, but it has limitations.
The price-to-earnings ratio is calculated by dividing a company’s current market capitalization (stock market) by its earnings per share. This can be misleading as it doesn’t consider dividend yield, which may change over time and affect how much investors are willing to pay for shares in that company.
Additionally, there’s no guarantee that this type of analysis will continue forever because other metrics, such as price-to-earnings growth (PEG) and the dividend yield, may be more suitable.
The PEG ratio allows for more granularity in company valuation. It can be seen as an improved alternative compared with the traditional metrics such as price-to-earnings (P/E) ratios or enterprise multiple.
Absolute vs. Relative P/E
Absolute P/E
The numerator of this ratio is typically the current stock price, while the denominator can be trailing earnings per share (EPS) (from the trailing twelve months [TTM]), estimated earnings per share for the next twelve months (forward P/E), or a combination of trailing earnings per share from the last two quarters and forward earnings per share for the next two quarters. It is critical to understand that when comparing absolute P/E to relative P/E, absolute P/E indicates the P/E for the current time period. For instance, if the company is trading at $100 today and the TTM earnings per share are $2, the P/E ratio is 50 ($100/$2).
Relative P/E
The relative P/E ratio compares the current absolute P/E to a baseline or a range of previous P/Es over a specified time period, such as the prior decade. Relative P/E indicates the proportion or percentage of previous P/Es that the present P/E has attained. While relative P/E typically compares the current P/E to the range’s peak, investors may also compare the current P/E to the range’s bottom, determining how close the current P/E is to the historical low. If the current P/E is less than the previous figure, the relative P/E will be less than 100%. (whether the past high or low). If the relative P/E ratio is more than 100 percent, this indicates that the current P/E has approached or exceeded the previous figure.
Justified P/E Ratio
The “justified” P/E ratio is the price-to-earnings ratio justified by using the Gordon Growth Model. However, this model does not work for all industries and can be misleading in some cases.
A justified P/E ratio will have no more than three digits, with dividends included in earnings for calculation purposes and debt conversion rates from an equity perspective.
This variant of the widely used P/E ratio considers several underlying basic characteristics, including the cost of equity and growth rate. The formulae are determined independently of the usual P/E ratio.
In other words, the two ratios should result in two distinct outcomes. Suppose the price-to-earnings ratio is less than the justifiable price-to-earnings ratio. In that case, the firm is undervalued, and acquiring the shares will result in profits if the alpha is sufficient. Alpha Alpha is a performance metric that compares an investment to a relevant benchmark index, such as the S&P 500.
An alpha of one (the default value is zero) indicates that the return on investment beat the general market average by 1% over a defined time period when closed.
What is considered a good Price-to-Earnings ratio?
The P/E Ratio can be used to indicate how expensive or cheap a stock is.
The Price-to-Earnings ratio will differ depending on the company’s industry and what type of price per share investors are willing to pay. A low P/E ratio suggests that investors are not too confident about future growth potential, while a high P/E ratio indicates investors are optimistic about future growth potential.
P/E ratios vary from industry to industry, so the value can be used as a general guideline for what is considered a good or bad price-to-earnings ratio in different types of industries.
Some industries have higher average P/E ratios, while others have lower ratios. For example, the average P/E ratio in oil and gas is usually around 60, whereas healthcare has an average of about 20.
It’s essential to keep in mind that P/Es are relative figures, and there is no single “good” PE ratio because it depends on what company you’re comparing them against.
Conclusion
The Price to Earnings Ratio is a vital indicator of the health and value of a company. A stock with a low price-to-earnings ratio (P/E) will be highly undervalued, whereas an overpriced one has potentially high risk associated with it. The P/E can also help you identify which sectors are most attractive or unattractive for investing in that day and determine if shares may be an appropriate purchase at any given point in time.
However, as you have read, this isn’t the only metric to use when evaluating a company’s worth as it has its faults.
