The price-to-earnings ratio (P/E ratio) is a tool used to determine a company’s value, and can alternatively be referred to as the ‘earnings multiple’ or ‘price multiple’. Used by investors and analysts, this calculation measures the current share price against the company’s earnings per share (EPS).
Such information provides insight into the comparative value of a share and demonstrates whether a company is currently undervalued or overvalued.
It can also indicate whether investors anticipate future growth. By examining historical patterns, a company might use the ratio to analyse its performance over time. 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 being calculated and what it is being used for.
P/E ratio formula and calculation
Calculating the P/E ratio is quite straightforward, you just divide a company’s share price (or market value per share) by its EPS:
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 P/E ratio is 10x (meaning 10 times the earnings).
Of course, EPS can be determined in different ways, resulting in the 2 most commonly used varieties of P/E ratio: trailing and forward.
The trailing variety examines earnings performance over the previous year, while the forward calculation incorporates the 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 P/E ratio
Using forward estimates of EPS to determine the P/E ratio is useful when considering the projected value of a business. However, as this is only based on an educated guess, and therefore subject to a number of variables, the metric can be unreliable.
For instance, a company may have its own reasons to underestimate or overestimate future earnings. The forward-focused calculation is, therefore, the less common of the 2 ratios.
Trailing P/E ratio
Trailing P/E employs the more concrete calculation of EPS based on the past 12 months. As long as earnings have been reported correctly, this is a more objective metric that investors can trust, as it is not based on a guess.
However, this does not mean the trailing ratio is the perfect measure. For instance, in considering only past performance, it cannot take future growth into account.
Valuation from P/E
P/E can be used 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 ratio reveals what the current market is prepared to shell out for the company’s shares based on earnings, past or future, and therefore reveals 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.
An example of the P/E ratio
Taking Coles Group Ltd (ASX: COL) as an example, the share price at the start of 2020 was $16.15, with a trailing EPS of 89 cents. Therefore, the P/E ratio is calculated as follows:
16.15 ÷ 0.89 = 18.16
When rounded, this can be expressed as a ratio of 18.2x. Or, put another way, investors paid around $18.20 for every dollar earned (based on the previous year). This number is particularly useful in determining the value of Coles stock when compared with other operators in the same industry group.
P/E tells us a number of things about shareholder expectations. A relatively low 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 may indicate how much growth investors anticipate in future earnings for the stock.
P/E compared to earnings yield and the price-to-earnings-to-growth (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 and the PEG ratio.
This metric is the inverse of P/E, where EPS is divided by the share price and expressed in percentage form. Accordingly, this provides the same information as P/E but in a different manner.
While earnings yield focuses on the rate of return for the investment, 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 earnings (or even negative earnings), whereas the P/E is not useful here.
The PEG ratio is a variation on P/E in that it provides more comprehensive information by taking account of the connection between P/E and the growth in earnings.
A low PEG (less than 1) indicates that the share price underestimates earnings growth, while a higher PEG (more than 1) 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), whereas relative P/E compares against a benchmark of past ratios over a particular time frame, such as 5 or 10 years.
When talking about P/E, it is the absolute metric that is generally accepted as the common standard metric. However, the relative ratio can be a useful tool for taking into account developments over time.
P/E ratio limitations and other considerations
As worthwhile as the P/E ratio is, all we end up with is a number that can be interpreted 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 be used to effectively compare shares across different sectors. For example, you wouldn’t compare the P/E ratio of a retail share against a finance share. Similarly, P/E does not effectively deal with companies that are not profitable.
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.
When employed correctly, it can provide a very meaningful insight into stock value. It is certainly not the only metric of its kind, but it is one of the most important and widely used.