Business, Legal & Accounting Glossary
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.
There are multiple versions of the ratio depending on the type of earnings and time period used. Three examples are:
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.
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.
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.
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.
Ideally, the performance spread should be “monotonic”, meaning that Quintile 1 outperforms Quintile 2, Quintile 2 outperforms Quintile 3, and so forth.
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This glossary post was last updated: 22nd March, 2020