The price-to-earnings ratio is an important indicator when analyzing firms for investment purposes, what it is, how to calculate it, and how to use it to compare investments. Is a stock’s price reasonable or excessive? This is a fundamental issue for any investor, and it may be answered in a variety of ways. However, one of the greatest places to begin is by examining the price-to-earnings ratio, a metric that every investor should be aware of and comprehend.
What is the P/E ratio?
PE ratio is a measure that compares the current stock price of a firm to its earnings per share (EPS), which may be computed using either historical data (for trailing PE) or forward-looking projections (for forwarding PE). It is a common component of stock research that investors use to:
To identify outliers, compare the stock prices of comparable firms.
Determine if the stock is underpriced, fairly priced, or overpriced.
Determine, depending on the stock’s worth, whether to purchase, sell, or keep it.
The “PE ratio” may seem complex, but it’s basically simply a comparison between how the public perceives a firm (its stock price) and how well the company is doing (its EPS). The reading may also be applied to market indexes such as the S&P 500, Dow Jones Industrial Average, and Nasdaq.
How to figure out the P/E ratio?
Simply put, the P/E ratio is what you would pay for $1 of a company’s earnings. The P/E ratio formula is:
Stock Price / Earnings Per Share = Price-to-Earnings (P/E) Ratio (EPS)
The P/E ratio is published on the majority of financial websites, so you do not have to calculate it yourself. However, it is always helpful to know where the statistics come from.
A P/E ratio incorporates a company’s stock price, which may be discovered on a variety of websites devoted to stock analysis. However, when it comes to earnings per share (EPS), some websites and sources use trailing twelve months (TTM) earnings, while others use the fiscal year, which often ends on December 31, but may terminate at other periods.
Therefore, if a stock is selling at $20 per share and generates $2 in trailing twelve-month EPS, its P/E ratio is 10 ($20 / $2).
Earnings is a company’s net income. Earnings per share (EPS) is calculated by dividing the company’s net income by the number of outstanding shares. (Note for dividend investors: Earnings are determined prior to the distribution of dividends.)
To calculate Microsoft’s P/E ratio, for instance, you must first determine the company’s earnings per share.
Microsoft has announced an EPS of $5.36 for the trailing twelve months (TTM), which includes the four most recent quarters of reported financials. The number of outstanding shares is 7,673 billion. Microsoft’s stock price as of April 25, 2020, is $174.55 per share. Its P/E ratio is thus 32.57 ($174.55 / $5.36).
However, this statistic alone provides little insight into Microsoft’s price or future prospects.
Why is the price-to-earnings ratio important?
The P/E ratio indicates how much you must invest for every dollar in earnings as an investor. “This is a fast and simple gauge for comparing a stock to its competitors,” Muoz explains.
For instance, if the P/E ratio is 10, investors may fairly expect to gain $1 for every $10 invested. If the P/E ratio is greater, you must invest more for each dollar of earnings. And if it is smaller, you need to invest less to get $1 in returns.
In order to obtain a good bargain on an undervalued firm, investors seek companies with low P/E ratios.
Braun-Bostich explains that the P/E ratio does not indicate if a stock is expanding, losing money, or has a high level of debt. She claims that several startups and growth stocks have “astronomical” P/E ratios. Therefore, it is essential to carefully consider other facts.
Three variants of the P/E ratio
Although the arithmetic behind the P/E ratio is simple — price divided by earnings — there are several methods to factor the price or earnings utilized in the computation.
The price-to-earnings ratio is typically computed using the current price of a stock. However, one may also use the average price over a specified time period. Regarding the earnings portion of the calculation, however, there are three distinct ways to the P/E ratio, each of which provides different information about a stock.
Trailing Twelve Month (TTM) Earnings
One technique to determine the P/E ratio is by using a company’s 12-month earnings history, and this is called the trailing P/E ratio or trailing twelve-month earnings (TTM). Incorporating historical earnings offers the advantage of utilizing real, recorded data, and this method is extensively used to evaluate businesses.
Numerous websites, including Google Finance and Yahoo! Finance, use the trailing P/E ratio. Popular investment applications M1 Finance and Robinhood also use TTM earnings. Recently, each of these websites indicated that Apple’s P/E ratio was about 33. (as of early August 2020).
It is also possible to compute the price-to-earnings ratio using an estimate of a company’s future earnings. While the forward P/E ratio, as it is known, does not benefit from reported statistics, it does benefit from utilizing the best available information on how the market anticipates a company’s performance over the next year.
Morningstar employs this technique, which it refers to as Consensus Forward PE. Using this measure, Morningstar estimates Apple’s PE to be around 28. (as of early August 2020).
The Shiller P/E Ratio
Utilizing average earnings over time is the third method. The best-known illustration of this method is the Shiller P/E ratio, commonly known as the CAP/E ratio (cyclically adjusted price-earnings ratio).
The Shiller PE is computed by dividing the price by the ten-year average earnings, adjusted for inflation. It is often used to determine the value of the S&P 500 index. Currently, the Shiller PE of the S&P 500 is a little around 30. (as of early August 2020).
What does the PE ratio indicate?
A high PE ratio indicates that investors anticipate a high amount of future earnings and robust growth. The share price has increased faster than earnings in anticipation of a performance improvement.
A low PE ratio may result when a stock’s price declines but earnings stay mostly stable.
As with many other investment formulas, the benefit of the PE ratio is that it enables investors to compare firms using a single computation. For instance, hundreds of firms in the two major UK indexes would take hundreds of hours to examine their financial statements. However, utilizing a PE ratio as a filter enables an investor to decrease the number of options by excluding those that do not meet a certain condition.
Some investors may see a high PE ratio as advantageous, and a higher PE indicates that future growth prospects are strong because the firm is tiny or the market is developing fast. Others favor a low PE because it indicates that expectations are not too high and the firm is more likely to surpass earnings estimates.
Buying a stock is equivalent to purchasing a piece of a company’s future earnings. Earnings will attract a greater price for businesses that are anticipated to expand more rapidly.
Earnings per share may be ‘trailing’ or ‘forward,’ with the former taking into account earnings from the previous several years and the latter depending on projections. A corporation with a high trailing PE may be considered more dependable than one with a forward PE in the twenties.
What does a P/E ratio tell you about a stock?
A high or low P/E ratio is not always good or bad, unlike pay or the number of cherries on an ice cream sundae. Not everything is black and white. The P/E ratio of a corporation indicates how investors value the company. Do they believe that future earnings will increase, remain the same, or maybe decrease?
A low P/E ratio indicates that earnings are anticipated to decline in the future. Consider the horse business. Before the invention of the automobile, it may have been beneficial to hold stock in a horse ranch – if “Horse Inc.” stock existed, it might have had a high price. Then, the automobile was created. Investors may have sold Horse Inc. shares in anticipation of a decline in future earnings. As the stock price declined, Horse Inc.’s P/E ratio would also decline.
A high P/E ratio indicates that future profit growth is anticipated. Let’s revisit the horse example. As investors understood the potential of these four-wheeled moving objects, the stock of “Vehicles Inc.” would have likely surged upon the invention of cars. The stock might have increased prior to the realization of gains, and the P/E ratio would have increased due to the greater stock price.
As an investor, it is crucial to understand how the market perceives this stock. You could agree, or you might disagree. And from there, your investment choices may develop.
What is a good P/E ratio for stocks?
Defining a “good” or “poor” PE ratio is challenging. As is the case with so many aspects of financial markets, it is difficult to apply a clear rule. Examining a company’s valuation in relation to a wide stock index or the industry in which it operates is a good technique to better understand its worth.
For instance, a PE of 15 for a home construction firm is meaningless unless the average PE for the house building investor is 27. The firm is hence undervalued compared to the sector as a whole and may see outperformance if it surpasses expectations. Alternatively, a firm with a high PE compared to its industry may suffer if it fails to fulfill projections.
Similar to the trend following in technical analysis, PE ratios fluctuate over time, and a firm may experience times when it is overvalued and undervalued by the market.
The simple answer is that it depends; it relies on the current state of the market, the anticipated future growth rate of the firm, and the predictability of that growth.
The P/E ratio is a good shorthand for determining whether investors are optimistic or bearish on the stock since it is mostly determined by Wall Street’s growth expectations for a firm.
In general, stocks with a higher P/E ratio are regarded as more costly, whilst stocks with a lower P/E ratio are considered more affordable.
Throughout history, the average P/E ratio of the stock market has fluctuated between 15 and 17.
However, the average P/E of the stock market has changed throughout time for various factors and is seldom traded exactly at 15-17. For instance, when investors are often more optimistic in bull markets, average P/E ratios fluctuate well over 15-17.
In bear markets with economic recessions, periods with higher interest rates, or times of general unpredictability, the average P/E ratio of the stock market has fluctuated below 15-17.
Therefore, a “low P/E” or “high P/E,” or “good P/E” may be very relative based on the current market circumstances and the average current P/E of the stock market.
Why is P/E a better way to compare stocks of different companies?
You may believe it’s simple to determine how “expensive” stock is; just glance at the stock price. But this is less beneficial than the P/E ratio. A stock’s value is represented by its stock price. However, what is a stock? It is one share of ownership in a corporation. It’s worth relies not only on the firm’s value but also on the number of outstanding shares. Consider the pizza. Is a $1 slice of pizza expensive? It depends on the size of the component. You must also consider the size of the piece of stock.
By measuring how much a stock costs per dollar of earnings, the P/E ratio accounts for the size of the “slice of pizza.” When examining the P/E ratio of a corporation, you see the price of one dollar’s worth of earnings.
How to determine whether a P/E Ratio is good or bad?
In the end, there is no definitive criterion for a good P/E ratio. In general, though, many value investors prefer a lower P/E ratio. Again, these ratios are often employed in a comparative sense, so whether something is good or terrible depends on what it is compared to.
To give you a feel of the market average, many value investors would refer to the range of 20 to 25 as the average P/E ratio. Similarly to golf, the measure indicates that a firm is a better investment the lower its P/E ratio.
However, this implies a value-based perspective when analyzing the market. If you want to invest in stocks of bigger, less volatile companies, you may be ready to pay more for an investment with a higher P/E ratio.
How to use the P/E ratio?
The most prevalent use of the P/E ratio is to determine the value of a stock or index. The greater the ratio, the pricier the stock is compared to its earnings, and the cheaper the stock, the smaller the ratio.
Thus, stocks and equity mutual funds may be categorized as either “growth” or “value” investments. For instance, an investment with an above-average price-to-earnings ratio may be categorized as a growth investment. With a PE of about 123, Amazon is an example of a growing corporation. An investment with a P/E ratio below the average would be considered a bargain investment. With a price-to-earnings ratio below 9, Citigroup would be considered a bargain stock.
The P/E ratio enables comparisons between two or more corporations. Given that a company’s stock price informs you nothing about the company’s total value, this may be beneficial. Moreover, comparing the stock price of one firm to that of another company reveals nothing about their respective investment worth.
Investors should be good with the P/E ratio and how to utilize it to analyze share prices. However, it is merely one of several accessible measures, and it should not be used by itself, nor should it be used to compare organizations in various industries. However, it is a useful method for determining if a stock is a bargain or not.