What is the Price to Earnings (PE) ratio?

What is the Price to Earnings (PE) ratio and how can it be used to help investors analyse what they should pay for a stock?

Ah! The famous “Price to earnings ratio”. This is viewed as the ultimate measure by most as to what a stock is actually worth.

The PE ratio is simply the price of a stock relative to its earnings per share. This is a common metric used by investors to analyse what they should pay for a stock. It is used as a measure to interpret how much money a firm is currently earning relative to its valuation and how much the company expects to earn in the future, relative to what the business is expected
to be worth.

For traditional “value investors” companies which had high PE ratios are generally viewed as being expensive, while those with lower ratio’s often provide greater levels of value. Firms which have a high price to earnings ratio are generally considered to:

  • Have above average business prospects and potentially in a phase of rapid expansion/growth.
  • Have the ability to generate significant amounts of free cash flow (money) on an ongoing basis.
  • Have captured high levels of investor confidence and demonstrate an ongoing sustainability to their business. This potentially includes companies who aggressively repurchase their own shares or have paid increasing dividends on a yearly basis.
  • Be positioned in a highly favourable industry which may have above average business prospects, such as e-commerce or technology.

On the other hand firms which have a low price to earnings ratio are considered:

  • To have below average growth prospects and may potentially experience contractions in their business.
  • To be unable to generate excess funds for their shareholders, potentially being forced to reinvest all of their earnings in the business to sustain their operations.
  • Have very low levels of investor confidence. This includes firms which have potentially missed their earnings forecasts on several occasions and have potentially cut their dividend payments.
  • Be positioned in an industry which is considered to be highly unfavourable for business, such as the aviation industry or heavy industrials.

Forward Price to Earnings Ratio & Yield

The price to earnings ratio is calculated on a forward basis, particularly for firms which are experiencing rapid levels of growth. For example, a firm which has a current price to earnings to ratio of 30 and is growing earnings at 40% per annum is generally considered to be highly undervalued as its current earnings will grow significantly. On the other hand, a firm which has a price to earnings of 15 and stagnant earnings is often considered to be fairly valued.

A firm’s price to earnings ratio is one important metric used in valuation. It is particularly useful when utilizing the future prospects of the firm. Remember that a company’s PE ratio depends entirely on the state of the business, so you may often wind up with exactly what you paid for!

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Motley Fool contributor Marcello Pinto has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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