What is a P/E ratio?

What is a P/E ratio?

  • February 28, 2022
  • 313

Why are P/E ratios useful?

P/E ratio stands for price-to-earnings ratio. It is the ratio of a company’s share price to its earnings per share (EPS). Investors use this ratio to compare performances of similar companies and to compare companies against their own historical records. The price-to-earnings ratio is sometimes also called the price multiple or the earnings multiple.

 

Basically, the P/E ratio tells you the dollar amount you can expect to invest in a company in order to have an ownership share that equates to one dollar of the company’s earnings. A high P/E ratio might indicate that a stock’s price is high relative to its earnings and potentially suggests that the stock is overvalued. On the other hand, a low P/E ratio might mean that a stock is undervalued.

 

Calculating a P/E ratio and the two main types of P/E ratios

To calculate a P/E ratio, divide the company’s stock price by its earnings per share. To find out a company’s current stock price, simply type its ticker into any finance website.

 

Determining a company’s earnings per share is slightly more complicated. There are two main types of EPS measurements, and they are used to calculate the two primary types of P/E ratios: forward P/E and trailing P/E. One type of EPS figure is called “trailing 12 months” or “TTM.” This data point shows how the company has performed over the past year. The second kind of EPS comes from a company’s earnings report and represents the company’s best estimate of what it will earn in the future. Analysts also calculate forward P/E based on their own EPS estimates.

 

Each type of P/E ratio has advantages and disadvantages. Trailing P/E is the most widely used form of the metric because it is the most objective. Forward P/E is always based on an educated guess. However, a company’s performance in the past does not always correlate to how it will fare in the future, so for this reason some investors prefer to look at forward P/E.

 

P/E ratio calculation example

Say you want to compare two companies that make air conditioners. Company A’s share price is $60, and Company B’s share price is $10. An investor might initially think that the $10 stock is the best value because it’s the least expensive, but this isn’t necessarily the case. A P/E ratio gives a more complete picture of an investment than a stock price does. Say Company A is located in Selangor, where demand for air conditioners is high. This company earns a profit of $100,000 per year. Company B is located in Kuala Lumpur, where demand for air conditioners is lower. It makes a profit of $10,000 per year.

 

You know each company’s share price and each company’s earnings. To set up an apples-to-apples comparison, there is one more piece of information required. You need to know how many shares each company has issued to calculate the value of each share relative to the company’s overall earnings. This data point is called earnings per share, or EPS.

 

If Company A has 50,000 outstanding shares and $100,000 in earnings, this would mean that each share has a claim on EPS of $2. Now that you have determined Company A’s EPS, you can find its P/E ratio. Simply divide the company’s share price ($60) by its EPS ($2) to get a P/E ratio of 30. This tells you that the stock is trading at 30 times the company’s earnings per share.

 

Now, you can calculate Company B’s P/E ratio to effectively compare the two companies. Say Company B has 10,000 outstanding shares and $10,000 in earnings, giving it an EPS of $1. Company B’s stock price is $10 per share, so it has a P/E ratio of 10. In other words, it is trading at 10 times its earnings. So, in this case, Company B may be undervalued – not because of its lower stock price, but because of its lower P/E ratio. A lower P/E value means that an investor is paying less per dollar of a company’s overall earnings.

 

The P/E ratio is just one piece of the puzzle

Although the P/E ratio is one of the most popular ways to evaluate a stock, it is not the only indicator investors should consider. For example, some stocks might have low P/E ratios because they have low growth potential. Looking at the scenario from above, if Company B only sells air conditioners in Kuala Lumpur, it might not be as likely to grow as Company A in Selangor. However, if both companies look like they will grow at similar rates, Company B might be the better investment because of its low P/E ratio.

It is also important to remember that a high P/E ratio isn’t always a bad thing, especially a high trailing P/E. Maybe Company A has recently invented an energy-efficient air conditioner and is poised for growth. This might not be reflected in its trailing P/E, but could be evident in its forward P/E.

Both types of P/E ratios give investors valuable insights about stocks and allow them to make helpful comparisons between companies. However, when evaluating investments holistically, it is important to look at other factors – like dividends, projected future earnings, and other data points – in addition to P/E ratios.

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