Financial analysts and investors use the price-to-earnings (P/E) ratio to determine a company’s value.
At its simplest level, the ratio reveals what the current market is prepared to shell out for the company’s shares based on past or future earnings. It shows what people are prepared to invest for each dollar earned.
How does the P/E ratio work?
The P/E ratio measures the current share price against earnings per share (EPS) to determine a company’s value. This calculation is also referred to as the ‘earnings multiple’ or ‘price multiple’.
The price-to-earnings ratio provides insight into a share’s comparative value and indicates whether a company is currently undervalued or overvalued.
The P/E ratio can also indicate whether investors anticipate future growth. A company might use the P/E ratio to analyse its performance over time by examining historical patterns. Similarly, analysts might use it to make comparisons between aggregate markets.
So, what is a good P/E ratio? There is no simple answer to this question, as it depends on how it is calculated and what it is being used for. A high P/E ratio can indicate a share is overvalued. Conversely, a low P/E ratio can indicate a share is undervalued.
But what constitutes a high or a low P/E ratio will depend on the company’s industry. Technology stocks, for example, tend to have a higher P/E ratio than consumer stocks.
P/E ratio formula and calculation
Calculating the P/E ratio is relatively straightforward — you just divide a company’s share price (or market value per share) by its earnings per share:
P/E ratio = market value per share ÷ earnings per share
For example, if the share price is $10 for a company earning $1 per share, then the price-to-earnings ratio is 10x (meaning 10 times the earnings).
Of course, EPS can be determined in different ways, with two most commonly used varieties of P/E ratio: trailing and forward.
The trailing variety examines earnings performance over the previous year. The forward calculation incorporates anticipated future earnings to determine the ratio.
A separate construction of the P/E ratio looks at longer-term trends by considering earnings averages over 10 years (P/E 10) or even 30 years (P/E 30). This can be useful in accounting for fluctuations in the overall business cycle, particularly when looking at the value of a share market index overall.
Forward ratio…
Using forward estimates of EPS to determine the P/E ratio is useful when considering the projected value of a business. However, it is based on an educated guess and therefore subject to several variables, so the forward P/E ratio can be unreliable.
A company may have reasons to underestimate or overestimate future earnings. The forward-focused calculation is, therefore, the less common of the two P/E ratios.
And trailing…
The trailing P/E ratio employs the more concrete calculation of EPS based on the past 12 months. This is a more objective metric that investors can trust, as it is not based on a guess — as long as trailing earnings have been reported correctly.
However, this does not mean the trailing ratio is the perfect measure. For instance, in considering only past performance, it cannot take expected growth into account.
Valuing a company
We can use the P/E ratio in different ways. It might not be the only metric that values a company, but it is one of the most commonly used.
At its simplest level, the P/E ratio reveals what the current market is prepared to shell out for the company’s shares based on earnings, past or future, and therefore shows what people are prepared to invest for each dollar earned.
For instance, at a P/E of 10x, you would expect to earn $1 for every $10 you pay.
Take Coles Group Ltd (ASX: COL) as an example, the share price at the end of trade on 16 March 2023 was $17.74, with a trailing EPS of 83.7 cents. Therefore, we can calculate the P/E ratio as follows: 17.74 ÷ 0.837 = 21.19
When rounded, this can be expressed as a ratio of 21.2x. Or, put another way, investors paid around $21.20 for every dollar earned (based on the previous year). P/E ratios are particularly useful in determining the value of a stock when compared with other operators in the same industry group.
Investor expectations
P/E ratios tell us several things about shareholder expectations. A relatively low P/E ratio could mean that investors believe the company is struggling to perform as well as others in the same industry. Or it may show the stock is simply undervalued.
Conversely, a high P/E ratio may indicate how much growth investors anticipate in future earnings for the stock. Companies with a high growth rate tend to have higher P/E ratios. A lower P/E ratio can indicate investors do not expect the same extent of earnings growth.
There’s no specific P/E ratio that indicates a share is cheap or expensive, just as there is no such thing as a good P/E ratio. However, analysts typically consider stocks with P/E ratios of below 15 as cheap, while shares with a P/E above 18 can be thought of as expensive. Of course, the P/E ratio of a share will depend on investor expectations of the company’s earnings and cash flow.
What about earnings yield and the PEG ratio?
Of course, the P/E ratio is not the only measure available to investors. Other metrics sometimes used to assess company value include the earnings yield, cash flow ratio, and the price-to-earnings-to-growth (PEG) ratio.
Earnings yield
This metric is the inverse of P/E, where we divide EPS by the share price and express it in percentage form. Accordingly, this provides the same information as P/E but in a different manner.
Earnings yield focuses on the rate of return for the investment, while the P/E ratio provides a more direct focus on growth in value over time.
The earnings yield assists analysis where a company has no (or negative) earnings, whereas the P/E is not useful here.
PEG ratio
The PEG ratio is a variation of P/E. It provides more comprehensive information by considering the connection between P/E and the growth in earnings.
A low PEG (less than one) indicates that the share price underestimates earnings growth. A higher PEG (more than one) shows investors have overestimated growth.
PEG is an example of how P/E can be used in other calculations to reveal even more about a stock’s value.
Absolute vs relative P/E
You may also come across references to absolute and relative P/E. The absolute ratio is calculated in the usual fashion detailed above (based on the current EPS). Relative P/E compares against a benchmark of past ratios over a particular timeframe, such as five or 10 years.
When talking about P/E, the absolute metric is generally accepted as the common standard metric. However, the relative ratio can be valuable for considering developments over time.
Limitations and other considerations
As worthwhile as the P/E ratio is, all we end up with is a number we can interpret in various ways. So, it does come with certain limitations.
It is particularly beneficial when comparing companies within the same industry. However, it is not an absolute measure that can effectively compare shares across different sectors. For example, you wouldn’t compare the P/E ratio of a travel share against a financial share. Similarly, P/E does not effectively deal with companies that are not profitable or have negative earnings.
The P/E ratio has many applications for investors, companies, and analysts, but it is important to have a strong understanding of what it means and how it can be used to help you assess a company’s performance.
It can provide a meaningful insight into stock value when employed correctly. It’s not the only metric of its kind, but it is one of the most important and widely used.