Define: Price To Earnings Ratio

Business, Legal & Accounting Glossary

Definition: Price To Earnings Ratio



Advertisement



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 rebalance 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.


Advertisement




Cite Term


To help you cite our definitions in your bibliography, here is the proper citation layout for the three major formatting styles, with all of the relevant information filled in.

Page URL
https://payrollheaven.com/define/price-to-earnings-ratio/
Modern Language Association (MLA):
Price To Earnings Ratio. PayrollHeaven.com. Payroll & Accounting Heaven Ltd. April 05, 2020 https://payrollheaven.com/define/price-to-earnings-ratio/.
Chicago Manual of Style (CMS):
Price To Earnings Ratio. PayrollHeaven.com. Payroll & Accounting Heaven Ltd. https://payrollheaven.com/define/price-to-earnings-ratio/ (accessed: April 05, 2020).
American Psychological Association (APA):
Price To Earnings Ratio. PayrollHeaven.com. Retrieved April 05, 2020, from PayrollHeaven.com website: https://payrollheaven.com/define/price-to-earnings-ratio/

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: 22nd March, 2020