The price-to-earnings ratio, or PE ratio, is one of the most widely used methods of valuing a company’s stock. It is used by analysts, investors and traders to help determine whether a company is being fairly valued by the market, relative to its peers. However, it is by no means a fool-proof measure and should be used in conjunction with other measures of valuation and broader research.
What is the price-to-earnings ratio?
The price-to-earnings ratio is a fundamental analysis tool that is calculated by dividing the current company stock price by yearly earnings per share. Company analysis looks at financial ratios and accounting statements to determine how a company is performing and whether or not it may be a good investment.
The PE ratio is determined by dividing the company’s stock price by its earnings per share, with the resulting figure being the number of years it will take for the business to earn its current price. Here’s an example:
Company X’s stock price is currently $40. The company has 100 million shares on issue and last year had earnings before interest and tax (EBIT) of $200 million, or $2 per share. Dividing 40 by 2 gives us a price-to earnings ratio (also called a “multiple) of 20, meaning it would take 20 years for the company to earn back its valuation at current levels. A trader or investor can then compare company X’s PE ratio with that of other companies to see whether it is fairly valued at present or not. The ratio can also be used across an entire index, such as the S&P 500.
What is a forward P/E ratio?
Whereas a normal P/E ratio looks at the most recent year for total earnings, a forward P/E ratio is based on the estimated earnings predicted by analysts for the upcoming year. Both ratios are based on the current stock price.
If forward P/E is lower than normal P/E, this means that analysts are expecting earnings growth in the upcoming year. A drastically lower ratio means that a large amount of growth is expected. On the other hand, if forward P/E is higher than normal P/E, analysts are forecasting lower growth prospects for the company.
Calculating the ratio
There are two ways of calculating the ratio:
Trailing PE Ratio = price/earnings
Price = current share price
Earnings = earnings over past year; total the past four quarterly earnings amounts
This number uses the businesses most recent earnings, taken from company reports.
Forward PE Ratio = price/forward earnings
Price = current share price
Forward earnings = expected earnings next year; total the analyst expected earnings for the next four quarters
The forward PE ratio is based on analyst’s projections of a company’s earnings for the year ahead. For instance, if the consensus estimate among analysts was for company X to grow its earnings per share 10% this year to $2.20, its PE ratio falls to 18.18.
What are the benefits of the PE ratio?
Arguably the strongest feature of the PE ratio is that it provides a relatively simple way to compare the valuations of different stocks: you don’t need to be an expert trader to know that a lower PE ratio is preferably to a higher one, all things being equal.
Its major shortcoming, however, is that it’s too simple to be used in isolation. A PE ratio will not tell you how fast a company’s earnings are rising or falling, nor does it tell us anything about a company’s revenue, how much debt it is carrying or whether it is winning or losing market share. This is all-important information that a canny investor would want to know before making a decision to buy or short the stock.
How to use a PE ratio when trading
Price to earnings ratios are really only useful for apples-to-apples comparisons, for instance, if General Motors has a ratio of 14 and Ford has a ratio of 18, that’s an indication GM’s stock may be undervalued, or that Ford’s is overvalued. Armed with that information, a trader and investor may form a view about where each stock is heading: is GM due for a rally? Or is Ford’s stock likely to tank?
However, it is also perfectly possible that the divergence in the two company’s ratios is justifiable, which is why more research is needed before making a decision to invest or trade. For instance, Ford’s earnings may be growing, while GM’s may be stagnating or going backwards.
Is there such a thing as a good PE ratio?
In a word, no: it’s all relative. A company that is growing its earnings quickly deserves a higher multiple than one that is stagnating or growing slowly. That’s why it makes little sense to compare the PE ratio of a tech company with that of a banking stock.
Other ways to value stocks
The PE ratio is a good place to start when comparing the valuations of different companies, but there are numerous other methods investors should be aware of. Here are a few other ways to value stocks:
Price/earnings-to-growth (PEG) ratio
The PEG ratio measures a company’s existing PE ratio against the expected growth in its earnings. To calculate this, divide the PE ratio by the rate of growth.
Using the Company X example (a PE ratio of 20, divided by 10% earnings growth) gives us a PEG ratio of 2. As a rule of thumb, analysts usually consider a stock with a PEG ratio of less than 1 to be undervalued.
Price-to-sales/revenue ratio
To determine a stock’s price to sales ratio, investors and traders divide a company’s market value (its share price multiplied by the number of shares on issue) by the value of its revenue or sales over the past year. This is a popular way to value “growth” stocks, especially in the tech space, where sales often grow faster than earnings in the early years. It is also useful in valuing companies that have negative earnings.
Price-to-book (P/B) ratio
The P/B ratio is calculated by dividing a company’s market valuation by its book value – which can be worked out by dividing a company’s market value per share by the value of its assets per share (minus debt). This can be useful when comparing the value of similar companies with similar growth profiles. A P/B ratio of less than one means a company is worth less than the value of its assets, which can be a sign that it is undervalued, but also that the company is in trouble. This metric is especially popular among so-called value investors like Warren Buffett.
Is the PE ratio a good way to value stocks?
The PE ratio is an extremely useful tool for valuing companies, but it shouldn’t be the only item in a trader or investors tool kit. It should be considered alongside other means of valuation, as well as broader research into the company’s performance and prospects.
Price-to-earnings ratios: advantages and disadvantages
P/E ratios can be useful, and here is a summary of the advantages:
- They are simple to calculate when doing company analysis.
- The ratios factor in both earnings and cost (share price).
- They can provide a quick assessment of whether a stock is over or undervalued.
However, P/E ratios also have drawbacks, including the following:
- The ratio is quick to calculate but assessing whether a stock is under or overvalued requires more work than simply looking at the raw number.
- They are not useful if the stock has negative earnings.
- They do not consider growth prospects in the company, unlike forward P/E and PEG ratios.
- Different stocks have different P/E ranges; some tend to always be high and others always low. Making an informed decision using P/E requires additional research.
Similar to other fundamental analysis tools, the P/E ratio it is not perfect when it comes to making investment decisions. If traders decide to use it as part of their stock research, they could develop a trading plan first for how it will be implemented. As part of the plan, this could include risk-management protocols, including having a stop-loss exit point and only dedicating a portion of available funds into any single trade to help control losses if the trade doesn’t move as expected.
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