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Using the Price-to-Earnings Ratio as a Quick Way to Value a Stock
Image by Maddy Price © The Balance 2020
Value investors and non-value investors alike have long considered the price-earnings ratio, known as the p/e ratio for short, as a useful metric for evaluating the relative attractiveness of a company’s stock price compared to the firm’s current earnings.
Made popular by the late Benjamin Graham, who was dubbed the “Father of value investing” as well as Warren Buffett’s mentor, Graham preached the virtues of this financial ratio as one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis, often offering some modifications and additional clarification so it had added utility when viewed in light of a company’s overall growth rate and underlying earning power.
As you discover how useful the P/E ratio can be, however, keep in mind that you can’t always rely on price-to-earnings ratios as the be-all and end-all yardstick in determining whether a company’s stock is expensive. There are some significant limitations, partly due to accounting rules and partly due to the inaccurate estimates most investors apply when projecting future growth rates.
Explaining the P/E Ratio
Before you can take advantage of the p/e ratio in your own investing activities, you must understand what it is. Simply put, the p/e ratio is the price an investor is paying for $1 of a company’s earnings or profit.
In other words, if a company is reporting basic or diluted earnings per share of $2 and the stock is selling for $20 per share, the p/e ratio is 10 ($20 per share divided by $2 earnings per share = 10 p/e).
For the sake of conservatism, use diluted earnings per share when calculating the P/E ratio so you account for the potential or expected dilution that can or will occur due to things like stock options or convertible preferred stock.
This is especially useful because, if you invert the p/e ratio by taking it divided by 1, you can calculate a stock’s earnings yield. This can allow you to more easily compare the return you are actually earning from the underlying company’s business to other investments such as Treasury bills, bonds, and notes, certificates of deposit and money markets, real estate, and more.
As long as you do your due diligence, looking out for phenomena such as value traps, viewing both the individual stocks you hold in your portfolio, and your portfolio as a whole, through this lens can help you avoid getting swept away in bubbles, manias, and panics. It forces you to look through the stock market and focus on the underlying economic reality.
For those who are inexperienced with investing, most financial portals and stock market research sites automatically figure the price-to-earnings ratio for you. Once you have this number, It can help you differentiate between a less-than-perfect stock that is selling at a high price because it is the latest fad among stock analysts and a great company that may have fallen out of favor and is selling for a fraction of what it is truly worth.
P/E Ratios by Industry
Different industries have different p/e ratio ranges that are considered normal for their industry group. For example, health care companies may sell at an average p/e ratio of 34, while energy sector companies may only trade at an average p/e ratio of 12. There are exceptions, but these variances between sectors and industries are perfectly acceptable.
They arise, in part, out of different expectations for different businesses. Software companies usually sell at larger p/e ratios because they have much higher growth rates and earn higher returns on equity, while a textile mill, subject to dismal profit margins and low growth prospects, might trade at a much smaller multiple. From time to time, the situation is turned on its head.
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In the aftermath of the Great Recession of 2008-2009, technology stocks traded at lower price-to-earnings ratios than many other types of businesses because investors were frightened. They wanted to own companies that manufactured products and that people would continue purchasing no matter how strained their finances; companies like Procter & Gamble, which makes everything from laundry soap to shampoo; Colgate-Palmolive, which makes toothpaste and dish soap; Coca-Cola; PepsiCo; and The Hershey Company.
There is a saying in the international investing market for wealthy families that sums up this sentiment and tendency succinctly: “When the going gets tough, the tough buy Nestlé.” This saying refers to Nestlé, the Swiss food giant that is one of the largest companies in the world and has a stable of products that generate billions of dollars in nearly every country, no matter how terrible things get.
From coffee, pasta, and baby food to ice cream, pet supplies, and beauty products, it is almost impossible for a typical member of Western Civilization to go a year without somehow, some way, directly or indirectly putting cash in Nestle’s coffers, which explains one of the reasons it is one of the most successful long-term investments in existence.
When an Industry Is Overpriced
One potential way to tell when a sector or industry is overpriced is when the average p/e ratio of all of the companies in that sector or industry climb far above the historical average. Historically, this has spelled trouble. The repercussions of such overpricing showed in the technology crash following the dot-com frenzy of the late 1990s and, later, in the stocks of companies linked to real estate.
Investors who understood the reality of absolute valuation knew it had become a near mathematical impossibility for equities to generate satisfactory returns going forward until the excess valuation had either burned off or stock prices had collapsed to bring them back in line with fundamentals. Men like John Bogle, the late founder of the Vanguard Group, went so far as to sell off all but a fraction of their stocks, moving the capital to fixed income investments such as bonds.
Such situations tend only arise every few decades but when they do, tread carefully and make sure you know what you are doing.
Benjamin Graham was fond of averaging profit per share for the past seven years to balance out highs and lows in the economy because if you attempted to measure the p/e ratio without it, you’d get a situation where profits collapse a lot faster than stock prices making the price-to-earnings ratio look obscenely high when, in fact, it was low.
Comparing Companies Using P/E
In addition to helping you determine which industries and sectors are overpriced or underpriced, you can use the p/e ratio to compare the prices of companies in the same area of the economy. For example, if company ABC and XYZ are both selling for $50 a share, one might be far more expensive than the other depending upon the underlying profits and growth rates of each stock.
Company ABC may have reported earnings of $10 per share, while company XYZ has reported earnings of $20 per share. Each is selling on the stock market for $50. What does this mean? Company ABC has a price-to-earnings ratio of 5, while Company XYZ has a p/e ratio of 2.5. This means company XYZ is much cheaper on a relative basis.
For every share purchased, the investor is getting $20 of earnings as opposed to $10 in earnings from ABC. All else being equal, an intelligent investor should opt to purchase shares of XYZ. For the exact same price, $50, he is getting twice the earning power.
Limitations of the P/E Ratio
Just because a stock is cheap doesn’t mean you should buy it. Many investors prefer the PEG Ratio, instead, because it factors in the growth rate. Even better is the dividend-adjusted PEG ratio because it takes the basic price-to-earnings ratio and adjusts it for both the growth rate and the dividend yield of the stock.
If you are tempted to buy a stock because the p/e ratio appears attractive, do your research and discover the reasons. Is management honest? Is the business losing key customers? Is it simply a case of neglect, as happens from time to time even with fantastic businesses? Is the weakness in the stock price or underlying financial performance a result of forces across the entire sector, industry, or economy, or is it caused by firm-specific bad news? Is the company going into a permanent state of decline?
Once you get more experienced, you will actually use a modified form of the p/e ratio that changes the “e” portion (earnings) for a measure of free cash flow. You can try something called owner earnings. Basically, use it, adjusted for temporary accounting issues, and try to figure out what you’re paying for the core economic engine relative to opportunity costs. Then, construct a portfolio from the ground-up that not only contains individual components that were attractive but also together reduces risk.
P/E Ratio Primer: Why the Price to Earnings Ratio Is Crucial
Wouldn’t it be great if there were a single piece of information that would tell you everything you need to know about whether to buy or sell a stock? YupвЂ¦ that sure would be great. Unfortunately, it doesn’t exist.
However, there is one number that does a surprisingly good job of conveying a lot of information about almost every stock. It’s a number that can be used in many ways: on a stand-alone basis for comparing one stock to another or to evaluate entire markets. It’s the price-to-earnings ratio, usually called the P/E ratio or the P/E multiple or simply the PE (with or without the “/”).
In this primer, we define the P/E ratio, explain how to interpret it, describe some ways people use it, and tell you when to ignore it. Along the way, we also introduce some related measures. That’s a lot to cover, so let’s jump in.
Defining the P/E Ratio
As its name indicates, the P/E ratio is quite simply a company’s stock price, P, divided by its (annual) earnings, E. So, for example, if XYZ Co.’s stock is priced at $90 and its earnings per share is $6, its P/E ratio is 15.
Of course, this example produced a nice round number (we like simple examples). In real life, the P/E ratio is likely to have something other than zero to the right of the decimal point. Don’t let that throw you off. And you can ignore anything beyond the first decimal place. It really doesn’t matter if the exact P/E ratio is 15.32 or 15.34; 15.3 is good enough.
The P/E ratio quite literally tells us, “Investors are willing to pay (insert P/E ratio as a $ value here) today for every $1 of this company’s earnings.” So, in the case of XYZ Co., investors are willing to pay $15 for every $1 of the company’s earnings. We can also say the stock is “trading at 15 times earnings.”
Turning It Upside-Down
Now, you may be thinking, “Why would I pay anything more than $1 to get $1 of a company’s earnings?” Perhaps the best way to answer that is to introduce one of the related measures mentioned earlier, the earnings-to-price, or E/P, ratio. We obtain this by turning the P/E ratio upside-down. The E/P is less famous than the P/E but is also quite useful. In our example, we invert 15/1 and get 1/15, or 0.0667.We’ll express as a percent: 6.67%.
You can think of the E/P as the return you would earn by paying today’s stock price to get your hands on the earnings per share. In our example, you would be paying $90 to get $6 in earnings per year. And remember, that’s just the return you would get from the earnings. It doesn’t include any return from an increase in XYZ Co.’s stock price.
If investors were willing to pay only $1 today for $1 of earnings, that would equate to a return of 100%. Nice if you can get it but completely unrealistic. That would be such a great deal, investors would buy more and more of the stock. That would push up the stock’s price, which would push down the E/P ratio to a more reasonable level.
Interpreting the P/E
Note that as a stock’s P/E ratio goes up, its E/P goes down, and vice versa — that’s just math. What this means is that as the P/E ratio increases, the “return” or “yield” each dollar of earnings represents decreases. That’s what the lower E/P reflects. This is why many people say that stocks with a high P/E ratio are overvalued.
But what is considered a high P/E? What is a low P/E? Let’s look at the P/E ratio for the U.S. stock market over time, as represented by the S&P 500 index.
The blue line shows the monthly P/E ratio for the S&P 500 over the past 90 years. The green line is the average over that entire time, which is about 17.0.
The thing about an average, though, is that if you compute it over a different period of time, it often changes. If we exclude the wild period of the Financial Crisis of 2008вЂ“2009, the average PE is about 16.1. So take your pick. We can say that a stock with a P/E ratio significantly higher than 16 to 17 is “expensive” compared to the long-term average for the market, but that doesn’t necessarily mean the stock is “overvalued.”
The Details Matter
If a stock has a high P/E ratio, we can interpret that to mean that investors are willing to pay a high price for each dollar of that company’s earnings (assuming those earnings stay the same, which we’ll discuss a bit later).
To help you decide whether a stock really is overvalued (and there is no official pass/fail test that says, “Yes, this stock is overvalued”), you need to know why investors have sent its P/E ratio upward. This takes us to the fine print of computing the P/E ratio. To really understand what the PE is telling you, it is important to dig into its components a bit more deeply, especially the earnings part, but also price.
Which EPS, Actual or Forecasted?
First, we need to know which earnings per share value was used to compute the P/E ratio. One choice is to use actual earnings — the sum of the four most recent quarterly earnings per share. This is sometimes shown as EPS (ttm), where “ttm” = “trailing twelve months.” An alternative would be forecasted earnings, usually an average of various stock analysts’ forecasts of the next four quarters of earnings. Both approaches have merit.
A big advantage of using actual EPS is that those earnings are, well, actual. They are not a result of inherently uncertain forecasts of things that affect future earnings. Such things can include future sales, expenses, new product development, etc. Also, it is easy to obtain actual EPS, while earnings forecasts can be harder to find, especially for smaller companies that are not followed by many analysts.
The disadvantage of actual earnings is that they are yesterday’s news. So many factors could make the coming year’s EPS significantly different from the most recent actual EPS. Consider an energy company’s actual versus forecasted earnings if crude oil sold for $40 per barrel last year but is headed for $70 this year. Or earnings of a firm whose brand was the trendsetter last year but seems to have lost its mojo.
Also note that earnings are affected by accounting rules that can distort the picture of a company’s profitability. (Although by and large, accounting rules do a good job of holding companies, ahem, accountable to readers of their financial statements.) Sometimes a company’s earnings are significantly affected by one-time events, positive or negative. In such a case, you are better off using forecasted earnings rather than the prior year’s actual earnings.
You will also want to know whether a P/E ratio was computed using a “basic” or “fully diluted” EPS. “Fully diluted” results in a lower EPS (and thus a higher PE).
Are High PEs Irrational?
Although it is quite common to use last year’s earnings in the P/E ratio, the result is inherently a bit of a mishmash, because price is intrinsically forward-looking. Today’s price reflects the market’s consensus expectations for future earnings. This gets at the heart of why some stocks have stratospheric P/E ratios — sometimes well over 100.
For example, in early May 2020, Amazon’s stock price was $1,591 per share. At the time, its prior year’s earnings were $6.15 per share, and the EPS forecast for the coming year was double that, at $12.34 per share. That gave Amazon a P/E multiple of 258.7 based on actual earnings or 128.9 based on forecasted earnings. Both are obviously many times greater than the average of the S&P 500.
Are investors crazy? These PEs equate to EPs of 0.387% and 0.776%, respectively. Who would buy a stock with an expected return of less than 1%? And these PEs are equivalent to saying it would take either 128.9 or 258.7 years to recoup your money if you were to buy the stock at this price, assuming you are counting on Amazon generating the same earnings, year after year after year.
But the stock price is telling us something very different. The price is looking forward and is telling us that investors expect Amazon’s earnings to continue to grow significantly over time. Remember, analysts are forecasting that Amazon’s earnings will double this year versus last year. If earnings continue to double, in four years the EPS would be $98.40. Given the May 2020 price, that would result in a P/E multiple of 16.2. Yes, exactly average for the overall market. If you think Amazon’s earnings might be on that kind of trajectory, maybe today’s PE isn’t so crazy after all.
This is why it is difficult to say whether a high PE means a stock is overvalued. It depends on one’s outlook for future earnings. However, a high PE should make you stop and think about why the stock is priced so high relative to its earnings. The same thing applies to the overall stock market. If the market’s PE is high relative to historical averages, maybe that’s a warning sign. But maybe it means investors are optimistic about future earnings. That’s one of the things that makes the P/E ratio so useful; it helps us to ask the right questions.
What if earnings are negative? In that case, the P/E ratio is meaningless and unusable. Sorry, but there’s just no getting around it. Most sources of PE data simply put “N/A” or “NM” (not meaningful) for companies with negative earnings.
Comparisons Are Useful
The PE also allows us to compare stock valuations in a meaningful way. Price by itself doesn’t tell us much. Let’s return to XYZ Co., priced at $90, and compare it to ABC Co., priced at $240. Both are in the same industry. Is ABC Co. overvalued because its price is higher than XYZ’s? Of course not. Price alone doesn’t tell us much.
But we do know XYZ Co.’s P/E ratio is 15, and ABC Co.’s EPS of $12 gives it a P/E ratio of 20. Now we have something useful. Either investors believe ABC’s earnings will grow faster than XYZ’s, or there is reason to believe that ABC’s stock is overvalued. The same logic applies for deciding whether a stock is undervalued.
Earnings growth is embedded in another related measure called the PEG ratio: price/earnings/growth. Since that deserves its own discussion, we’ll cover it in a separate piece.
We mentioned that XYZ Co. and ABC Co. are in the same industry. That’s important, because “typical” PEs differ across industries. For example, PEs of tech companies are usually higher than those of media companies or utilities.
We can also compare P/E ratios across countries. The S&P 500’s PE is higher than the PE for major European stock indices. This may indicate investors expect faster earnings growth in the United States than in Europe. We can even compare the E/P, or earnings yield, to the yield on other types of investments, such as Treasury bonds or bank CDs. When the PE of the S&P 500 increases to the point where its EP earnings yield is lower than the yield on U.S. Treasury bills, we expect some money to flow out of the market into those risk-free T-bills.
The P/E ratio (P/E multiple) is a top contender for the title of most useful go-to number when it comes to analyzing individual stocks, comparing two or more stocks, judging whether the stock market overall has become too expensive and even to compare yields on other types of investments. It bundles a lot of information into one number and can be a great indicator of questions that need to be asked before investing your money.
Price Earnings Ratio
What is the Price Earnings Ratio?
The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price and earnings per share (EPS) Earnings Per Share Formula (EPS) EPS is a financial ratio, which divides net earnings available to common shareholders by the average outstanding shares over a certain period of time. The EPS formula indicates a company’s ability to produce net profits for common shareholders. . It is a popular ratio that gives investors a better sense of the value Fair Value Fair value refers to the actual value of an asset – a product, stock, or security – that is agreed upon by both the seller and the buyer. Fair value is applicable to a product that is sold or traded in the market where it belongs or under normal conditions – and not to one that is being liquidated. of the company. The P/E ratio shows the expectations of the market and is the price you must pay per unit of current earnings Net Income Net Income is a key line item, not only in the income statement, but in all three core financial statements. While it is arrived at through the income statement, the net profit is also used in both the balance sheet and the cash flow statement. (or future earnings, as the case may be).
Earnings are important when valuing a company’s stock because investors want to know how profitable a company is and how profitable Profit Margin In accounting and finance, profit margin is a measure of a company’s earnings relative to its revenue. The three main profit margin metrics are gross profit (total revenue minus cost of goods sold (COGS) ), operating profit (revenue minus COGS and operating expenses), and net profit (revenue minus all expenses) it will be in the future. Furthermore, if the company doesn’t grow and the current level of earnings remains constant, the P/E can be interpreted as the number of years it will take for the company to pay back the amount paid for each share.
P/E Ratio in Use
Looking at the P/E of a stock tells you very little about it if it’s not compared to the company’s historical P/E or the competitor’s P/E from the same industry. It’s not easy to conclude whether a stock with a P/E of 10x is a bargain, or a P/E of 50x is expensive without performing any comparisons.
The beauty of the P/E ratio is that it standardizes stocks Stock What is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms “stock”, “shares”, and “equity” are used interchangeably. of different prices and earnings levels.
The P/E is also called an earnings multiple. There are two types of P/E: trailing and forward. The former is based on previous periods of earnings per share, while a leading or forward P/E ratio Forward P/E Ratio The Forward P/E ratio divides the current share price by the estimated future (“forward”) earnings per share (EPS). For valuation purposes, a forward P/E ratio is typically considered more relevant than a historical P/E ratio. P/E ratio example, formula, and downloadable Excel template. is when EPS calculations are based on future estimates, which predicted numbers (often provided by management or equity research analysts Equity Research Analyst An equity research analyst provides research coverage of public companies and distributes that research to clients. We cover analyst salary, job description, industry entry points, and possible career paths. ).
Price Earnings Ratio Formula
P/E = Stock Price Per Share / Earnings Per Share
P/E = Market Capitalization / Total Net Earnings
Justified P/E = Dividend Payout Ratio / R – G
R = Required Rate of Return
G = Sustainable Growth Rate
P/E Ratio Formula Explanation
The basic P/E formula takes the current stock price and EPS to find the current P/E. EPS is found by taking earnings from the last twelve months divided by the weighted average shares outstanding Weighted Average Shares Outstanding Weighted average shares outstanding refers to the number of shares of a company calculated after adjusting for changes in the share capital over a reporting period. The number of weighted average shares outstanding is used in calculating metrics such as Earnings per Share (EPS) on a company’s financial statements . Earnings can be normalized Normalization Financial statements normalization involves adjusting non-recurring expenses or revenues in financial statements or metrics so that they only reflect the usual transactions of a company. Financial statements often contain expenses that do not constitute a company’s normal business operations for unusual or one-off items that can impact earnings Net Income Net Income is a key line item, not only in the income statement, but in all three core financial statements. While it is arrived at through the income statement, the net profit is also used in both the balance sheet and the cash flow statement. abnormally. Learn more about normalized EPS Normalized EPS Normalized EPS refers to adjustments made to the income statement to reflect the up and down cycles of the economy. The adjustments include removing .
The justified P/E ratio Justified Price to Earnings Ratio The justified price to earnings ratio is the price to earnings ratio that is “justified” by using the Gordon Growth Model. This version of the popular P/E ratio uses a variety of underlying fundamental factors such as cost of equity and growth rate. is used to find the P/E ratio that an investor should be paying for, based on the companies dividend and retention policy, growth rate, and the investor’s required rate of return WACC WACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt. The WACC formula is = (E/V x Re) + ((D/V x Rd) x (1-T)). This guide will provide an overview of what it is, why its used, how to calculate it, and also provides a downloadable WACC calculator . Comparing justified P/E to basic P/E is a common stock valuation method. Valuation Methods When valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions. These methods of valuation are used in investment banking, equity research, private equity, corporate development, mergers & acquisitions, leveraged buyouts and finance
Why Use the Price Earnings Ratio?
Investors want to buy financially sound companies that offer a good return on investment (ROI) ROI Formula (Return on Investment) Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will receive in relation to their investment cost. It is most commonly measured as net income divided by the original capital cost of the investment. The higher the ratio, the greater the benefit earned. . Among the many ratios, the P/E is part of the research process Equity Research Analyst An equity research analyst provides research coverage of public companies and distributes that research to clients. We cover analyst salary, job description, industry entry points, and possible career paths. for selecting stocks, because we can figure out whether we are paying a fair price. Similar companies within the same industry are grouped together for comparison, regardless of the varying stock prices. Moreover, it’s quick and easy to use when we’re trying to value a company using earnings. When a high or a low P/E is found, we can quickly assess what kind of stock or company we are dealing with.
Companies with a high Price Earnings Ratio are often considered to be growth stocks. This indicates a positive future performance, and investors have higher expectations for future earnings growth and are willing to pay more for them. The downside to this is that growth stocks are often higher in volatility and this puts a lot of pressure on companies to do more to justify their higher valuation. For this reason, investing in growth stocks will more likely be seen as a risky Risk Aversion Risk aversion refers to the tendency of an economic agent to strictly prefer certainty to uncertainty. An economic agent exhibiting risk aversion is said to be risk averse. Formally, a risk averse agent strictly prefers the expected value of a gamble to the gamble itself. investment. Stocks with high P/E ratios can also be considered overvalued.
Companies with a low Price Earnings Ratio are often considered to be value stocks. It means they are undervalued because their stock price trade lower relative to its fundamentals. This mispricing will be a great bargain and will prompt investors to buy the stock before the market corrects it. And when it does, investors make a profit as a result of a higher stock price. Examples of low P/E stocks can be found in mature industries that pay a steady rate of dividends Dividend A dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend. .
P/E Ratio Example
If Stock A is trading at $30 and Stock B at $20, Stock A is not necessarily more expensive. The P/E ratio can help us determine, from a valuation perspective, which of the two is cheaper.
If the sector’s average P/E is 15, Stock A has a P/E = 15 and Stock B has a P/E = 30, stock A is cheaper despite having a higher absolute price than Stock B because you pay less for every $1 of current earnings. However, Stock B has a higher ratio than both its competitor and the sector. This might mean that investors will expect higher earnings growth in the future relative to the market. The P/E ratio is just one of the many valuation measures and financial analysis tools that we use to guide us in our investment decision, and it shouldn’t be the only one.
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Price to Earnings Ratio (P/E Ratio)
The price to earnings ratio (P/E ratio) is the ratio of market price per share to earning per share. The P/E ratio is a valuation ratio of a company’s current price per share compared to its earnings per share. It is also sometimes known as “earnings multiple” or “price multiple”. Though Price-earning ratio has several imperfections but it is still the most acceptable method to evaluate prospective investments. It is calculated by dividing “Market Value per Share (P)” to “Earnings per Share (EPS)”. Market value of share can be taken from stock market or online and earning per share figure can be calculated by dividing net annual earnings to total number of shares (Net Annual Earnings/Total number of shares).
P/E ratio is a widely used ratio which helps the investors to decide whether to buy shares of a particular company. It is calculated to estimate the appreciation in the market value of equity shares.
The formula used to calculate the price to earnings ratio is:
Price to Earnings Ratio = Market Price per Share / Earnings per Share
The price to earnings ratio can also be calculated with the help of following formula:
Price to Earnings Ratio = Market Capitalization / Earnings after Taxes and Preference Dividends
The P/E ratio tells how much the market is willing to pay for a company’s earnings. A higher P/E ratio means that the market is more willing to pay for the earnings of the company. Higher price to earnings ratio indicates that the market has high hopes for the future of the share and therefore it has bid up the price. On the other hand, a lower price to earnings ratio indicates the market does not have much confidence in the future of the share.
The average P/E ratio is normally from 12 to 15 however it depends on market and economic conditions. P/E ratio may also vary among different industries and companies. P/E ratio indicates what amount an investor is paying against every dollar of earnings. A higher P/E ratio indicates that an investor is paying more for each unit of net income. So P/E ratio between 12 to 15 is acceptable.
For example, if company A shares are trading at $50/share and most recent EPS is $2/share. The P/E ratio will be $50/2$ = $25. This indicates that the investors are paying $25 for every $1 of company’s earnings. Companies with no profit or negative earnings have no P/E ratio and usually written as “N/A”.
Norms and Limits
A higher P/E ratio may not always be a positive indicator because a higher P/E ratio may also result from overpricing of the shares. Similarly, a lower P/E ratio may not always be a negative indicator because it may mean that the share is a sleeper that has been overlooked by the market. Therefore, P/E ratio should be used cautiously. Investment decisions should not be based solely on the P/E ratio. It is better to use it in conjunction with other ratios and measures.
The most obvious and widely discussed problem in P/E ratio is that the denominator considers non cash items. Earnings figure can easily be manipulated by playing with non cash items, for example, depreciation or amortization. If it is not manipulated deliberately, earnings figure is still affected by non cash items. That is why a large number of investors are now using “Price/Cash Flow Ratio” which removes non cash items and considers cash items only.
It is normally assumed that a low P/E ratio indicates a company is undervalued. It is not always right as this may be due to the stock market assumes that the company is headed over several issues or the company itself has warned a low earnings than expected. Such things may lead to a low P/E ratio.
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