The price to earning ratio is among the most popular methods of finding the valuation of a company’s stock against its historical evaluation and with other companies in the same industry or over the market. The PE ratio or PER, is the measure of a company’s stock value or share price to its earnings per share or EPS. It is one of the most important part of financial ratios used in providing insights on financial health of a company.
In simple terms, the P/E ratio helps identify if a stock value in the current market is overpriced, underpriced, or rightfully priced. This encourages better and more profitable investment decisions. Let us understand the Price to earning ratio, explore its different types, and know about its vital uses in investment decisions.
Price to Earning Ratio (P/E): Key Takeaways
- The price to earning ratio represents a measure of the ratio between the value of a share and its earnings. In totality, it is the proportion of the share price of a company to the total earnings of the shares.
- A high price to earning ratio is representative of an overpriced stock value of a company. This poses an expectation of high growth rates from investors.
- A financial enterprise making losses lacks a P/E ratio and is represented as N/A since it has no earnings to put in the denominator of the ratio. For cases where a company is in a state of balance (making no losses or gains), the P/E ratio is directly equivalent to the share price of the company and thus represented as N/A only.
- Trailing P/E and forward P/E are the two most commonly used price to earnings ratio. Besides, there is also absolute P/E and relative P/E.
Understanding Price to Earning Ratio (P/E): Definition
The price to earning ratio, also noted as price-to-earnings multiple, P/E ratio, PER, or simply P/E or PE refers to a relative value between the share price of a company to its total earnings per share. It is calculated by taking a ratio of the stock price to the earnings.
The price to earning ratio is a simple and effective way to evaluate financial enterprises and find out if they are undervalued or overvalued.
This is an important aspect for investors to know as it provides important input about the growth possibility of an enterprise by the assessment of the relative value of the enterprise’s stock.
Further, it comes in handy while comparing the valuation of a company with its historical valuation, with other companies in the industry, or against the overall market. Let us explore the various versions of the P/E ratio, its formula, and examples before understanding its significance.
The 2 Different Types of Price-to-Earnings Ratio (P/E)
There are two different versions of the price-to-earnings ratio based on the types of earnings or whether they are realized or projected.
1. Trailing Twelve Months Price-to-Earnings Ratio
As the name suggests, the trailing twelve-month price-to-earnings ratio is calculated by finding the proportion between the share price and the last four quarterly earnings per share (EPS) or the recent twelve-month period. It is easier to calculate the trailing PE ratio as companies release their financial results data including the Earnings per share (EPS) every quarter.
A timely analysis of the trailing twelve month PE ratio or TTM PE ratio provides vital insights into whether a stock price is being overheated. Besides, it provides insights into whether the overall market index is too low or high when compared to past price to earning ratios.
Notably, there is also the trailing PE ratio from continued operations. It makes substantial use of the operating earnings which excludes all the earnings from discontinued operations, accounting changes, and extraordinary items such as writedowns and one-off windfalls.
2. Forward Price to Earning Ratio
The forward price-to-earnings ratio represents the ratio between the current share price and the estimated earnings per share of the next four quarters or the projected earnings over the next twelve-months period.
Expertise is required to calculate the forward PE ratio since it incorporates the forecasting of sales, P&L, margins, and EPS. Based on the research and guidance of the company management, research analysts calculate the forward PE ratio by estimating the forward earnings.
The forward PE ratio is generally considered more useful than the TTM PE ratio since the previous four quarters share prices are already known whereas the projection of the next four quarters’ earnings would facilitate learning about the changes in stock prices.
The Formula of Price to Earning Ratio (P/E) and Its Calculation
The formula used to calculate the price-to-earnings ratio is given as follows:
“P/E Ratio = Market Value Per Share / Earnings Per Share”
A simple division of the stock price by the earnings per share or EPS gives you the PE ratio.
The stock price can be found over the internet as reported by stock tickers, representing the current value of stocks or shares as being paid by the investors. On the other hand, there are reports of the earnings per share (EPS) at different times.
Now, the EPS is given in two ways as we have discussed above. In the PE ratio of the following twelve months, EPS is given by the earnings per share of the latest four quarters (12 months or 1 year).
Another is the forward PE ratio in which the EPS is given by the earnings per share for the next four quarters (12 months or 1 year). This is found in the earnings releases provided by EPS guidance or the advice on what a company expects from its future earnings.
Price to Earning Ratio (P/E) Examples
Let us understand the PE ratio and its calculation from some suitable examples. They are discussed as follows:
- Say there is a company named XY Corporation. We can easily calculate the P/E ratio for XY corporation as of Feb, 2024, when the company’s stock price closed at $258.96. It is provided that the earnings per share (EPS) of the company for the trailing 12 months was $18.65.
Therefore, the P/E ratio of XY Corporation would be calculated as follows:
$258.96 / $18.65 = 13.89
- Now, the PE ratio value of the XY corporation is 13.89 which represents that XY corporation has 13.89 times its trailing earnings. This PE value is not of much use if you cannot compare it to the market stock values, stock industry group, XY corporation’s previous PE ratios, or preset standards such as the S&P 500.
- For instance, the PE ratio of XY corporation in this case is lower than the S&P 500 value which was 22 times the twelve-month trailing earnings as of Feb 2024.
- Alternatively, you will find a higher PE value of the XY corporation when compared to MPC’s value of 7. This means that investors will expect higher growth earnings than MPC in the future.
What does a High Price to Earning Ratio (P/E) mean?
If the earnings per share as expected grow in the future, there will be a spike in share prices and vice versa. If the share value falls much faster than the earnings per share value, there is a low price-to-earnings ratio. However, when the share prices spike much faster than the earnings per share, we get a high price-to-earnings ratio.
A high price-to-earnings ratio is indicative that a stock is more expensive than its earnings.
Vitality of Price-to-Earnings Ratio (P/E)
The PE ratio is highly vital in investment decisions and for analysts who compare company values to understand industry and market trends. Some of its prominent uses are noted below:
- A simple way its significance can be jotted is that the price to earning ratio refers to the price investors willingly pay for Rs 1 earning per share (EPS) of the company.
- The PE ratio is used to identify undervalued or overvalued stocks. In general terms, a high value of the PE ratio is representative of an expensive stock value that may fall in the future whereas a lower value shows that the stock is undervalued or cheap and its price may see a rise in the future.
- Another way the PE ratio helps is in the identification of the value or growth stocks. Similar to the above valuations, a high price-to-earnings ratio is associated with a growth stock whereas a low price-to-earnings ratio showcases a value stock.
- Besides, the PE ratio facilitates the comparison of companies as well. It helps compare a company’s valuation to another or compare a company’s valuation to its industry. Or simply, it helps compare a company’s valuation to a preset benchmark such as the S&P 500 index.
- Furthermore, the price-to-earnings ratio is instrumental in comparing the stock prices to total earnings. This facilitates the investors to understand the market value of the stock or simply the value the market is willing to pay for the stock.
Significant Limitations of Price-to-Earnings Ratio (P/E)
Despite the numerous uses of the price-to-earnings ratio, there are certain limitations to it as well which is why they must not be used single-handedly for investment decisions. These are understood as follows:
There are different valuation ranges of stocks in different industries.
The price-to-earnings ratio should be understood in context as it is a relative value. An investment decision should not be solely based on the PE ratio. Investors are advised to compare other important factors such as the records of the company, industry, and scale.
Price-to-Earnings Ratio (P/E): Alternatives that Work
1. Price-to-Book Ratio P/B
One prominent alternative to the PE ratio is the PB ratio (price-to-book ratio). It makes a comparison between the market value of a company to its book value. The book value indicates the net asset value of a company as per its balance sheet. The PB ratio is particularly useful for industries with tangible assets.
2. Price-to-Sales Ratio P/S
Another alternative is the price-to-sales ratio or PS which compares the company’s share price to its revenues. It provides insight into the value investors are willing to pay per dollar sale.
It is highly relevant for companies that are not profitable yet or startups or those that are in volatile earnings industries like the high tech industry.
3. Enterprise Value-to-EBITDA Ratio (EV/EBITDA)
The Enterprise Value-to EBTIDA ratio is yet another suitable alternative to the PE ratio and it is majorly used in capital-intensive industries like utilities and telecommunications.
It compares the valuation of an enterprise to its earnings before interest, depreciation, taxes, and amortization. It is a more holistic ratio than the PE ratio as it provides an account of the company’s cash levels and debt.
Price to Earning Ratio FAQs
Q1. What do investors expect from a high price-to-earnings ratio?
Ans: From a high price-to-earnings ratio, investors expect higher earnings growth from those companies with a lower PE ratio.
Q2. What is the major difference between the two types of price-to-earnings ratios?
Ans: There are two prominent types of PE ratio: the Trailing Twelve Month PE Ratio (TTM PE) and the Forward PE Ratio. These are based on the time period of the earnings per share (EPS).
Q3. Are PE ratios alone sufficient to make investment decisions?
Ans: No. Although the PE ratio is a good measure to evaluate a company’s stock and find its value against the industry’s group and the market, it is not alone sufficient to make a fully profitable and risk-free investment decision.
