The P/E ratio (price-to-earnings ratio) of a stock (also called its "P/E", or simply "multiple") is a measure of the price paid for ashare relative to the annual net income or profit earned by the firm per share. The P/E ratio can therefore alternatively be calculated by dividing the company’s market capitalization by its total annual earnings.
Unlike the EV/EBITDA multiple which is capital structure-neutral, the price-to-earnings ratio reflects the capital structure of the company in question. The price-to-earnings ratio is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with a lower P/E ratio. The P/E ratio can be seen as being expressed in years, in the sense that it shows the number of years of earnings which would be required to pay back purchase price, ignoring inflation and time value of money. The P/E ratio also shows current investor demand for a company share. The reciprocal of the P/E ratio is known as the earnings yield. The earnings yield is an estimate of the expected return from holding the stock if we accept certain restrictive assumptions
Defination
The P/E ratio is defined as:
However, the definition of its components may vary.
The price per share in the numerator is the market price of a single share of the stock. The earnings per share in the denominator depends on the type of P/E:
- "Trailing P/E" or "P/E ttm": Here earnings per share is the net income of the company for the most recent 12 month period, divided by the number of shares issued. This is the most common meaning of "P/E" if no other qualifier is specified. Monthly earning data for individual companies are not available, so the previous four quarterly earnings reports are used and earnings per share are updated quarterly. Note, each company chooses its own financial year so the timing of updates will vary from one to another.
- "Trailing P/E from continued operations": Instead of net income, this uses operating earnings, which exclude earnings from discontinued operations, extraordinary items (e.g. one-off windfalls and write-downs), or accounting changes. Note, longer-term P/E data, such as Shiller’s, use net earnings.
- "Forward P/E", "P/Ef", or "estimated P/E": Instead of net income, this uses estimated net earnings over next 12 months. Estimates are typically derived as the mean of a select group of analysts (note, selection criteria is rarely cited). In times of rapid economic dislocation, such estimates become less relevant as the situation changes (e.g. new economic data is published, and/or the basis of forecasts becomes obsolete) more quickly than analysts adjust their forecasts.
For example, if stock A is trading at $24 and the earnings per share for the most recent 12 month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of the stock is paying $8 for every dollar of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio (usually shown as Not applicable or "N/A"); sometimes, however, a negative P/E ratio may be shown.
By comparing price and earnings per share for a company, one can analyze the market’s stock valuation of a company and its shares relative to the income the company is actually generating. Stocks with higher (and/or more certain) forecast earnings growth will usually have a higher P/E, and those expected to have lower (and/or riskier) earnings growth will usually have a lower P/E. Investors can use the P/E ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal (especially the earnings growth rate), it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, companies, and time periods may be misleading.P/E ratio in general is useful for comparing valuation of peer companies in similar sector or group.
Since 1900, the average P/E ratio for the S&P 500 index has ranged from 4.78 in Dec 1920 to 44.20 in Dec 1999, with an average around 15.The average P/E of the market varies in relation with, among other factors, expected growth of earnings, expected stability of earnings, expected inflation, and yields of competing investments. For example, when US treasury bonds yield high returns, investors pay less for a given earnings per share and P/E’s fall.
Determining share prices
Share prices in a publicly traded company are determined by market supply and demand, and thus depend upon the expectations of buyers and sellers. Among these are:
- The company’s future and recent performance, including potential growth;
- Perceived risk, including risk due to high leverage;
- Prospects for companies of this type, the market sector.
By dividing the price of one share in a company by the profits earned by the company per share, you arrive at the P/E ratio. If earnings per share move proportionally with share prices the ratio stays the same. But if stock prices gain in value and earnings remain the same or go down, the P/E rises.
The earnings figure used is the most recently available, although this figure may be out of date and may not necessarily reflect the current position of the company. This is often referred to as a ‘trailing P/E’, because it involves taking earnings from the last four quarters.
Relationship between measures
Several of these measures are related to each other: given price, earnings, and dividend, there are 6 possible ratios, which come in reciprocal pairs:
- P/E ratio and earnings yield are reciprocals;
- P/D ratio and dividend yield are reciprocals;
- Dividend payout ratio (DPR) = Dividend/EPS, while the reciprocal is dividend cover (DC) = EPS/Dividend.
They are related by the following equations:
- P/E = P/D * DPR and P/D = P/E * DC;
- taking reciprocals, earnings yield = dividend yield * DC and dividend yield = earnings yield * DPR.
Interpretation
The average U.S. equity P/E ratio from 1900 to 2005 is 14 (or 16, depending on whether the geometric mean or the arithmetic mean, respectively, is used to average).
Normally, stocks with high earning growth are traded at higher P/E values. From the previous example, stock A, trading at $24 per share, may be expected to earn $6 per share the next year. Then the forward P/E ratio is $24/6 = 4. So, you are paying $4 for every one dollar of earnings, which makes the stock more attractive than it was the previous year.
The P/E ratio implicitly incorporates the perceived risk of a given company’s future earnings. For a stock purchaser, this risk includes the possibility of bankruptcy. For companies with high leverage(that is, high levels of debt), the risk of bankruptcy will be higher than for other companies. Assuming the effect of leverage is positive, the earnings for a highly-leveraged company will also be higher. In principle, the P/E ratio incorporates this information, and different P/E ratios may reflect the structure of the balance sheet.
Variations on the standard trailing and forward P/E ratios are common. Generally, alternative P/E measures substitute different measures of earnings, such as rolling averages over longer periods of time (to "smooth" volatile earnings, for example), or "corrected" earnings figures that exclude certain extraordinary events or one-off gains or losses. The definitions may not be standardized.
Various interpretations of a particular P/E ratio are possible, and the historical table below is just indicative and cannot be a guide, as current P/E ratios should be compared to current real interest rates (see Fed model):
N/A
A company with no earnings has an undefined P/E ratio. By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, even though a negative P/E ratio can be mathematically determined.
0–10
Either the stock is undervalued or the company’s earnings are thought to be in decline. Alternatively, current earnings may be substantially above historic trends or the company may have profited from selling assets.
10–17
For many companies a P/E ratio in this range may be considered fair value.
17–25
Either the stock is overvalued or the company’s earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in future.
25+
A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble.
It is usually not enough to look at the P/E ratio of one company and determine its status. Usually, an analyst will look at a company’s P/E ratio compared to the industry the company is in, the sectorthe company is in, as well as the overall market (for example the S&P 500 if it is listed in a US exchange). Sites such as Reuters offer these comparisons in one table. Example of SPY Often, comparisons will also be made between quarterly and annual data. Only after a comparison with the industry, sector, and market can an analyst determine whether a P/E ratio is high or low with the above mentioned distinctions (i.e., undervaluation, over valuation, fair valuation, etc).
Using Discounted cash flow analysis, the impact of earnings growth and inflation can be evaluated. The on-line calculator at Moneychimp allows one to evaluate the "fair P/E ratio". Using constant historical earnings growth rate of 3.8 and post-war S&P 500 returns of 11% (including 4% inflation) as the discount rate, the fair P/E is obtained as 14.42. A stock growing at 10% for next 5 years would have a fair P/E of 18.65.
The market P/E
To calculate the P/E ratio of a market index such as the S&P 500, it is not accurate to take the "simple average" of the P/Es of all stock constituents; since it is a capitalization-weighted index, the accurate method is to calculate a weighted average. In this case, each stock’s underlying market cap (price multiplied by number of shares in issue) is summed to give the total value in terms of market capitalization for the whole market index. The same method is computed for each stock’s underlying net earnings (earnings per share multiplied by number of shares in issue). In this case, the total of all net earnings is computed and this gives the total earnings for the whole market index. The final stage is to divide the total market capitalization by the total earnings to give the total market P/E ratio. The reason for using the weighted average method rather than ‘simple’ average can best be described by the fact that the smaller constituents have less of an impact on the overall market index. For example, if a market index is composed of companies X and Y, both of which have the same P/E ratio (which causes the market index to have the same ratio as well) but X has a 9 times greater market cap than Y, then a percentage drop in earnings per share in Y should yield a much smaller effect in the market index than the same percentage drop in earnings per share in X. One easy way of looking up a market index P/E ratio is to look up the P/E ratio of an ETF that tracks the index. For example SPY tracks the S&P 500 Index, while VTI tracks the Wilshire 5000 index.
A variation that is often used is to exclude companies with negative earnings from the sample – especially when looking at sub-indices with a lower number of stocks where companies with negative earnings will distort the figures.
In Stocks for the Long Run, Jeremy Siegel argues that the earnings yield is a good indicator of the market performance on the long run. The average P/E for the past 130 years has been 12.1 (i.e. earnings yield 8.3 percent).