Price To Earnings Ratio

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Definition: Price To Earnings Ratio


Price To Earnings Ratio

Video Guide For Price To Earnings Ratio




Full Definition of Price To Earnings Ratio


The price to earnings ratio (P/E) is the stock price divided by earnings per share (EPS).

The price to earnings ratio can also be computed by dividing market capitalization (stock price X shares outstanding) by net income. “Trailing” earnings – profits for the most recent four quarters – are used to compute the price to earnings ratio.

A “forward” price to earnings ratio, based on earnings estimates for the current or succeeding years, is also widely published. The price to earnings ratio of a stock is usually measured against those of equities with similar characteristics. A high price to earnings ratio may show the stock is richly valued; a low price to earnings ratio may indicate it has appreciation potential. But analysts will often differ on whether a particular price to earnings ratio is high or low. Moreover, the quality of earnings in the denominator of the price to earnings ratio will vary substantially. Finally, note that even comparisons among peers may be flawed when the firms have few earnings and their stock prices are based on capital appreciation potential.

The Price/Earnings Ratio (PE Ratio) is an equity valuation metric. It is also known as Earnings Multiple and Price Multiple. The ratio is referred to as the “multiple” because it indicates how much investors are willing to pay per dollar of earnings.

The PE Ratio is calculated by dividing the market value per share by the Earnings Per Share (EPS).

There are multiple versions of the ratio depending on the type of earnings and time period used.  Three examples are:

  • PE Ratio TTM:  uses the net income for the trailing twelve month (TTM) period divided into the average number of common shares over the same period
  • PE Ratio TTM from continuing operations:  uses the company’s operating earnings, excluding accounting changes, earnings from discontinued operations and extraordinary items
  • Projected PE Ratio:  uses the mean estimated current year or next year net earnings, as provided by analysts from various financial publications

Price/Earnings Ratio Interpretation

The PE Ratio is the most popular method of evaluating prospective investments.  Both price and earnings are readily available and represent the (inverted) earnings yield.  Note that for companies experiencing losses (negative earnings), the multiple will be reported as N/A, whereas the earnings yield will be a negative number.

The PE Ratio provides an indication of how much the market is willing to pay for a company’s earnings. A higher figure indicates that the market has high hopes for the future of the company and investors are willing to buy shares at a premium price.  However, a high earnings multiple may not signify a good investment due to share overpricing.

A lower earnings multiple indicates the market does not have as much confidence in the company.  This may not always be a negative investment factor because the share price may be undervalued.

It should be noted that “higher” and “lower” PE Ratio is subject to interpretation.  The mean value varies from industry to industry and for different time periods.

The most prominent problem with the PE Ratio is that the denominator includes non-cash items such as depreciation or amortization. The earnings can easily be manipulated by playing with these items. This is why a large number of investors now use the Price/Cash Flow Ratio which removes non-cash items and considers cash items only.

Quantitative Analysis

Good quantitative factors exhibit relationships with stock returns that not only have a fundamental and/or theoretical basis for stock returns but are also stable and persistent over time. The P/E Ratio is such a factor, having been correlated with past stock returns for decades and also expected to be correlated with future returns.

Investment Horizon

In the world of quantitative analysis, the investment horizon is referred to as “rebalance period”, indicating the period of time a stock is held before refreshing the portfolio holdings. While some quantitative factors achieve good results with weekly, monthly or quarterly rebalance, the P/E Ratio typically requires an investment horizon of at least 1 year to exhibit “good” results.

Quintile Back-Test

The Quantitative Analyst assesses individual stock factors by:

  • separating the stocks into quintiles (or deciles) based on the value of the factor
  • calculating the performance of each quintile based on rebalancing period and total back-test period
  • analyzing the spread of performance between Quintile 1 to Quintile 5

Ideally, the performance spread should be “monotonic”, meaning that Quintile 1 outperforms Quintile 2, Quintile 2 outperforms Quintile 3, and so forth.

Investor Sentiment

The P/E is sometimes referred to as an *Investor Sentiment* indicator. The P/E will move minute by minute as the price changes, as earnings changes usually happen only once a quarter. As the P/E goes up, it shows that current investor sentiment is that the company is worth more, its future prospects are bright, and sellers are only giving up their stock at higher prices. A dropping P/E is an indication that the company is out of favor with investors.

The median stock in the S&P 500 Index has historically had a P/E ratio of about 15. A lower P/E ratio likely implies a company is in its mature stage or has cyclical, inconsistent earnings. A very low P/E implies that investors believe earnings are likely to decline in the future. High growth companies can justify higher P/Es, but P/Es over 30 are difficult to sustain with earnings growth. They are considered speculative. Similarly, companies with no or negative earnings have non-applicable P/E’s, forcing those relying on using a multiple to lean on either price-to-book ratios or price-to-sales. Companies posting losses are frequently new companies or start-ups, oftentimes with excellent prospects, but not yet earning a profit.

P/E should never be used alone in valuing a company because earnings are fluid and can change due to a variety of circumstances. A company with a P/E of 5 is not necessarily a better investment than a company with a P/E of 30. Sometimes there are good reasons for a P/E to be low or high. The trick to investing wisely is knowing when the market has it right and when it does not.

P/E is most useful in comparing one investment to another. Just as a median S&P 500 company tends to have a P/E of 15, other industries and sectors of the economy have their own norms. A close competitor should have a similar P/E. If it does not, that can signal an investment opportunity or at least a subject for closer research. As companies used in the comparison become less similar, the P/E comparison increases in risk.


Related Phrases


Multiple
Earnings
Value investing
PEG ratio
Price to book ratio


Price To Earnings Ratio FAQ's


What Is a P/E Ratio?

The P/E ratio (Price to Earnings ratio) is defined as the market price per share of a stock divided by the stock’s earnings per share.

The P/E ratio (or “P/E”) is the most common and widely used of valuation metrics. Virtually every financial website displays it and it is commonly used as a jumping-off point for valuation discussions.

The P/E is a quick way to look at the valuation of a stock. One way to view it is as how many years it would take for you to recover your investment principal from the earnings a company generates, assuming no change in those earnings. For example, if you were to buy a company for $5 million that had an annual net income of $1 million — a P/E of 5 — it would take you 5 years to break even on that investment.

What Is A Trailing P/E?

This is the most commonly discussed P/E. Unless stated otherwise, you can probably assume that a displayed P/E is a trailing P/E. This is the one shown on sites such as Yahoo! Finance.

It is the current stock price divided by the earnings per share (EPS) from the last four reported quarters. To calculate it, go to a site such as Yahoo! Finance or Google Finance, look at the income statement summary pages, set the view to quarterly, and add up the EPS from the last four quarters. Then divide that total into the current stock price.

For example, if the company earned $0.37, $0.42, $0.26, and $0.22 in EPS over the last four quarters and the stock price was $17.33, then the P/E would be $17.33 / $1.27 = 13.64. When the next quarter is reported, the oldest quarter’s number is dropped so that the EPS used is always the four most recent quarters.

A critique of using trailing earnings as a source of valuation guidance is that they aren’t necessarily predictive of future earnings. For example, if a company’s P/E clocks in at a seemingly low 5.5, but those trailing earnings were courtesy of a cyclical peak, that 5.5 figure is overstating the company’s normalized earnings power.

What Is The Current P/E Ratio?

The least commonly referenced of the three versions of the P/E ratio, this is the stock price divided by the consensus analysts’ estimates for earnings in the current fiscal year. These are usually updated as the company reports earnings through the year, but actual company reported earnings are not used to calculate this.

To determine this one, go to a site such as Yahoo! or Google Finance or Morningstar, find the page which shows analyst expectations and look for the current year estimate of earnings. Divide that into the share price to get the current P/E.

What Does Forward P/E Mean?

This is the stock price divided by the consensus expected earnings for the next year, as opposed to the current or trailing year. The same procedure is used to calculate this ratio, but use the estimated earnings for next year, not this year.

A risk with using the forward P/E ratio is that, assuming earnings are expected to grow, it can be used to paint a somewhat rosier picture of a valuation than might otherwise be thought. Not surprisingly, analysts, investors, and companies advocating a growth stock tend to gravitate towards using forward P/E’s as they tend to portray valuations in a more favorable light. Another consideration worth noting is that ratio is based on analysts’ expected results which may turn out to be aggressive.


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Definition Sources


Definitions for Price To Earnings Ratio are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 29th November, 2021 | 0 Views.