Price to Earnings ratio can also be referred to as the price multiplier or the earnings multiple. The P/E ratio is a financial measure of a company’s share price relative to the annual net income per share or EPS.
P/E is used by investors and analysts to determine the current demand for the share. It can be used to compare one company’s share price value compared to previous years. It is also used for a fair comparison of many companies’ share values. A higher ratio shows an increased demand whether a lower one shows a lower demand.
P/E is called a multiple because it can identify how much an investor is willing to pay for one dollar of earnings. Many investors will avoid expensive P/E since they can be overvalued and will seek an undervalued one. The reason for that is because overvalued stocks are at risk of losing their stock value instead of increasing it, rather than an undervalued stock that has more chances to increase in value.
The formula to calculate the P/E ratio has as follows:
For example, if a company has a stock price of $20 and an EPS of $10, the P/E will be $2.
Note: When calculating the ratio you should bear in mind that what you see is a form of trailing 12-month (TTM) average. This means the last 12 months are taken into consideration in the EPS. It is also good to know that a company’s ratio can change daily since the stock price fluctuates on a daily basis while the EPS is updated quarterly when companies submit their earnings report.
The average ratio that investors are willing to buy is $20-$25. This means that investors are willing to buy a stock for $20-$25 for $1 of earnings. However, this number depends on the industry or the company itself since the average can vary from industry to industry and can be lower or higher.
For instance, companies in the high growth categories such as technology, biotech, start-ups, or stocks with a high growth orientation could have a higher P/E than the average stock market average. Amazon (AMZ) has a ratio of 93.32X compared to the internet e-commerce industry that has a P/E of 54.33X.
Note: The X at the end of the P/E ratio indicates how many times investors are willing to pay for the $1 price per earnings.
Since we used Amazon for the example let’s see some further explanation. Amazon is part of many indices since its one of the five biggest tech companies along with Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), and Facebook (FB). Considering the S&P 500 index, their ratio sits at 15.86. This means that Amazon’s earnings are more expensive than the overall index. An investor who wishes to invest in the S&P because of its relatively low P/E may consider not to invest in Amazon stocks due to its overvalued ratio.
As mentioned above, it depends on the investor’s appetite or risk-averse whether to prefer low P/E with the potential to grow over time.
Even though the ratio is a measure to help investors and analysts evaluate a stock, it does have its limitations. Like the example of Amazon, we have seen above that shows a P/E relatively expensive of 93.32, it does not paint the whole picture. If you consider that Amazon was IPO at $18 in 1997 and now it’s $3,162 you can see that just a small investment would have proved to be a great investment even when the stock was overvalued at $1,800 one year ago or $1,000 two years ago with a high P/E.
Another limitation is based on past performance (earnings). Even when a company updates it after its quarterly earnings report the P/E will still be based on past earnings. This can bring up two main issues. First, it is not updated in real-time and secondly, it does not indicate future performance. This is why when considering P/E as a measure investors and analysts should go further and identify news, innovations, and future forecasts of a company.
In addition, it does not take into consideration a company’s balance sheet analysis. A company that carries debt is definitely a factor that can have an impact on a company’s financial performance and valuation, but the ratio does not consider that.
When the earnings of a company are negative the P/E ratio will mean that the earnings per share are also negative. This indicates that a company is not profitable or is operating at a loss. It is mathematically possible to have a negative ratio, but it will not be reported if it has a negative value. This is why when you look at specific stocks the P/E datapoint is empty or N/A.
For example, companies like Uber (UBER) operate at a loss and do not provide a P/E ratio in their database.
The trailing ratio takes into account the performance and earnings of the past 12 months. This is why the P/E can never be in real-time since it can only be presented when calculating the last 12 months in the equation. For example, the stock price is divided by the trailing 12-months earnings per share.
The forward ratio takes into account the expected EPS growth. This number is a prediction of the earnings to be performed in the near future and helps investors and analysts to forecast if the company will be overvalued or undervalued on expected growth estimates. The numerator is the same but the denominator changes. You divide the stock price by the expected earnings growth.
The absolute P/E ratio is simply the stock price divided by the EPS or in other words, the same ratio that we have seen above. What is the difference? The difference is the EPS value where it can either be a trailing or forward-looking figure. The relative ratio comes to compare the absolute P/E ratio to the past one over a specific period of time and is express as a percentage. Overall, this number can tell investors what percentage of the past P/E the new serves. Moreover, it will show if it is relatively lower or higher than the previous one and help them understand the company’s path. The calculation is simple, you divide the absolute P/E from the historical.
Like every other financial measure that exists to help investors evaluate a company, P/E is here to do the same. It helps investors form a better view of a company in order to form a better investment decision. It is important to know the price of the stock you are considering paying for because what you are looking for might differ from what you are about to get. Are you willing to pay a higher price for a lower return? Or are you looking for the lowest price and hence the highest possible return? These questions are simply answered when looking at a company’s ratio. Since we have learned about the limitations of the P/E it is important to compare it with other measures before deciding on an investment.
Well done for learning new terminology and getting one step closer to the financial world. You can now read about Dividends and continue expanding your knowledge!!
Like every other financial measure that exists to help investors evaluate a company, P/E is here to do the same. It helps investors form a better view of a company in order to form a better investment decision. It is important to know the price of the stock you are considering paying for because what you are looking for might differ from what you are about to get. Are you willing to pay a higher price for a lower return? Or are you looking for the lowest price and hence the highest possible return? These questions are simply answered when looking at a company’s ratio. Since we have learned about the limitations of the P/E it is important to compare it with other measures before deciding on an investment.
Well done for learning new terminology and getting one step closer to the financial world. You can now read about Dividends and continue expanding your knowledge!!
