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Price-Earnings Ratio (P/E Ratio) Definition
The price-earnings ratio (P/E ratio) determines the value of the company by calculating the its current share price comparative to its per-share earnings. The price-earnings ratio is also often known as the price multiple or the earnings multiple.
The P/E ratio is calculated as: Market Value per Share / Earnings per Share
A Little More on What is the ‘Price-Earnings Ratio – P/E Ratio
Simply saying, the price-earnings ratio shows the dollar amount an investor expects to invest in a company to get one dollar of the company’s earnings. Thus, the P/E is often termed as the price multiple since it depicts how much investors intend to pay per dollar of earnings. If a company were already trading at a multiple (P/E) of 20, it implies that an investor intends to pay $20 for $1 of existing earnings. Price-earnings ratios are useful to allocate a relative value to a stock, investors have to use several others techniques to make decisions.
To compute the P/E ratio, you must know the earnings per share (EPS). EPS is most often taken from the past four quarters. This kind of price-earnings ratio is termed as trailing P/E, which you can calculate by subtracting a share value of the company at the start of the 12-month period from its value at the end of the period, adjusting the stock splits if any. Sometimes, price-earnings is taken from the analysts’ estimates of earnings projected during the coming four quarters. This kind of price-earnings is termed as projected or forward P/E. A third, not very widely used variation relies on the sum of the past two actual quarters and the projections of the next two quarters.
Calculating the P/E ratio for Wal-Mart Stores Inc. (NYSE:WMT),
Let’s say that as of November 14, 2017 Wal-Mart’s stock price reached at $91.09. The company’s profit for that year ended January 31, 2017 was $13.64 billion with number of shares outstanding as of 3.1 billion. Its EPS will be calculated as:
$13.64 billion / 3.1 billion = $4.40. Wal-Mart’s P/E ratio is, hence, $91.09/$4.40 = 20.70
Generally, a high P/E means investors are anticipating higher earnings growth in coming year compared to businesses having a lower P/E. A low P/E means either the business may presently be undervalued or it is doing extraordinarily well as compared to its past trends. When a company doesn’t have any earnings or is incurring losses, in both cases P/E is expressed as “N/A.” Though we can calculate a negative P/E, however, it is not a common convention.
The price-earnings ratio is a tool of standardizing the value of one dollar of earnings across the stock market. Theoretically saying, by considering the median of P/E ratios for a period of few years, one could make something of a standardized P/E ratio, which can be used as a benchmark to determine whether a stock is worth buying or not.
Limitations of ‘Price-Earnings Ratio – P/E Ratio
Similar to any other tool developed to let investors determine as to whether a stock is worth buying or not, the price-earnings ratio bears some considerable limitations, as investors may sometimes be led to think that there is just a single metric that gives a full insight into an investment strategy, which is never the case, virtually.
One key limitation of using P/E ratios became evident when P/E ratios of different companies were compared. Company valuations and growth rates may often differ radically between sectors because of the diverse ways businesses earn money and to the varied timelines during which they earn that money. As such, we should apply just P/E as a comparative tool when considering companies belonging to the same sector, as this type of comparison is the only kind that provides productive insight. Comparing the P/E ratios of an energy company, and a telecommunications company for example, may lead to a belief that one is evidently a superior investment, but this is not an accurate assumption.
The P/E ratio of the individual company is much more useful when taken with P/E ratios of other companies belonging to the same sector. For instance, an energy company can have a high P/E ratio, but this may be based on the trend in the sector instead of one just in the individual company. An individual company’s high P/E ratio, for instance, will be less cause for the concern when the whole sector shows the high P/E ratios.
Moreover, since a company’s debt influences both the shares price and the company’s earnings, the leverage can effect P/E ratios also. For instance, let’s say there are two similar businesses that differ mainly in the amount of debt taken. The one having more debt will be having lower P/E value than the one having less debt. However, if the earning is good, the one having more debt may have higher earnings due to the more risks it has assumed.
Another limitation to note for price-earnings ratios is that it is confined to the formula for calculating the P/E itself. Unbiased and accurate presentations of the P/E ratios are based on the accurate inputs of the market value of its shares and accurate earnings per share projections. While the market decides the value of shares and, as such, that data is available from a broad range of reliable sources, this is less so for the earnings, which are generally reported by the businesses themselves and therefore are manipulated easily. As earnings are a vital input in calculating P/E, adjusting them can impact P/E also.
Usually a high P/E ratio implies that investors are expecting higher growth in the future.
The average market P/E ratio is 20-25 times earnings.
The P/E ratio uses the estimated earnings to determine the forward looking P/E ratio.
Companies losing money don’t have any P/E ratio.
References for P/E ratio
- https://corporatefinanceinstitute.com › Resources › Knowledge › Valuation
- https://www.myaccountingcourse.com › Financial Ratio Analysis
Academic Research on P/E ratio
Assessing the predictive power of customer satisfaction for financial and market performances: Price–to–Earnings ratio is a better predictor overall, Rostan, P., & Rostan, A. (2012). International Review of Management and Marketing, 2(1), 59-74.
Dynamic effect of Tobin’s Q on price–to–earnings ratio, Sum, V. (2014). Managerial Finance, 40(6), 634-643.
Aggregate and regional house price to earnings ratio dynamics in the UK, Gregoriou, A., Kontonikas, A., & Montagnoli, A. (2014). Urban Studies, 51(13), 2916-2927.
Pengaruh Dividend Payout Ratio, Price to Book Value Ratio, dan Price to Earnings Ratio pada Return Saham di Bursa Efek Indonesia Periode 2009-2011, Antara, I. M. J. (2012). E-Jurnal Akuntansi.
Price to Earnings Ratio, Value to Book Ratio and Growth, Fernandez, P. (2017). (October 2, 2017).
[PDF] The Usefulness of Price to Earnings Ratio (P/E) in Predicting Share Price Behavior: A Review of Recent Evidence, Hashemzadeh, N., Davis, E., Wade, E., Prather, L. J., Topuz&, J. C., & Uzmanoglu, C. (2008). Compiled and Edited by: Vivek Bhargava, Alcorn State University Co-editor: Steve Wells, Western Kentucky University Editorial Assistant, 134.
[PDF] Price–to–Earnings Ratio and Expected Earnings Growth Rate in Global Equity Markets, Bakshi, G., & Chan, A. (2000). Price-to-Earnings Ratio and Expected Earnings Growth Rate in Global Equity Markets.
Stock Market Price–to–Earnings Ratio and Credit Spread: Dynamic Response and Causality, Sum, V. (2013). Available at SSRN 2335873.
Price–to–earnings ratio: A state-of-art review, Ghaeli, M. (2017). Accounting, 3(2), 131-136.