Smart investors always try to get the best possible deal on whatever security or asset they are buying. The better the deal, the higher the chance of generating a substantial amount of profit from the investment. To do so, value and non-value investors use a wide array of tools to try and analyze the actual value of an asset.
The price to earnings ratio (P/E) is one of the most widely used financial measurements when it comes to stock selection.
What is the Price Earnings Ratio?
Price-earnings ratio is a measure that seeks to ascertain the relationship between the price of a company’s stock and its earnings per share. Being a ratio, it is calculated by dividing a company’s current stock price by its earnings per share over a given time period (usually one year).
The ratio provides a way for investors to determine how much they would pay for every dollar of earnings. Value investors use the P/E ratio to determine whether a stock is overvalued or undervalued. The ratio can also reveal how a stock’s value compares with that of the industry average or a benchmark index for that matter.
Stock price expresses the value that investors are placing on an investment while the price to earnings ratio indicates the amount of money investors are willing to pay for every dollar of earnings. Given that P/E is calculated using earnings per share, the measurement is subject to manipulation by management and the specific accounting techniques they choose.
Looking at P/E allows you to consider what premium you are paying for a company’s earnings. It is up to you to decide whether the company’s expected growth warrants the premium at stake.
The two components used to calculate the price to earnings ratio are the stock price, which is set by forces of demand and supply in the market, and EPS, or earnings per share
Earnings per share are calculated by starting with the net income of the company, subtracting any dividends on preferred stock that the company must pay, and dividing the result by the number of outstanding shares. This metric gives insight into a company’s financial health. Earnings per share provide the E portion of the P/E ratio.
The price to earnings ratio is calculated using earnings per share of the last four quarters, a metric normally referred to as trailing earnings per share. P/E is usually only calculated for companies that are profitable, i.e., companies with positive earnings. A company that is losing money would have a negative P/E, but because a low P/E is a good sign and an even slightly negative P/E could mean that the company is losing a lot of money, negative P/E values are usually listed as N/A (not available) to avoid confusion.
For example, Company XYZ is trading at $50 a share and has trailing earnings per share of $10. The price to earnings ratio, in this case, will be 5
What this means is that investors will have to pay $5 for every dollar of the company’s earnings. In other words, the stock is trading at a multiple of 5. Since a trailing EPS was used, the ratio is considered a trailing price-earnings ratio. Whenever a future predicted EPS is used, then the ratio is considered a leading price/earnings ratio.
A stock with a lower P/E ratio relative to the industry average will often be a better value when compared to a stock with a higher P/E. A low P/E ratio is usually good as it allows investors to pay less for every dollar on earnings.
However, it is also important to note that a lower P/E ratio may at times be indicative of poor current and predicted performance. While an investor will be able to pay less for every dollar of earnings, should underperformance continue then investors may lose big.
Companies with higher P/E are expected to have higher earnings in the future, and they are usually expected to issue higher dividends. That is why investors are willing to pay a hefty amount for the earnings on offer, and why the price is so high. Companies with increasing earnings per share will most of the time see the market value of their share increase. It is up to the individual investor to do their analysis and decide if the high price and high P/E ratio are justified based on the company’s outlook, or if the stock is overvalued and not a good buy.
Price to earnings ratio is especially useful when comparing companies within the same industry. For example, the market price of company XYZ is $60 and has earnings per share of $10, its P/E, in this case, will be $6. If the industry P/E average is 8, it means the market value of company XYZ ought to be $80 (8X10) thus the stock as it stands is undervalued by $20. The investor’s job then would be to find out if there is some reason why XYZ will underperform its peers or if the stock has simply gone unnoticed and it’s a good time to snatch it up while the price is low.
Conversely, if the average P/E ratio of the industry is 4, then it means the stock is overvalued by $20 given that it ought to be trading at $40 ($10x4). Depending on the outlook for the company, this might be a good time to sell the stock.
Why the Price-Earnings Ratio Is Important
Given that P/E is the current price of a stock divided by previous earnings per share, it is always subject to daily change as stock price changes. As the price varies, P/E varies along with it in order to show the current price relative to past performance.
Price to earnings ratio is important because it gives clues about key fundamentals of a company such as its future growth prospects, investor confidence, and the amount of risk investors take on at its current price. If a company has a proven track record, then it is more than certain to have a higher P/E, relative to a company with a low P/E.
Companies with robust corporate governance command higher P/E than their peers as good oversight goes a long way in strengthening investor confidence in the stock. High and stable dividend-paying companies also command high P/E in part because it shows fundamental strength in a company’s ability to reward shareholders.
Value investors, who are always looking for bargains in the stock market, will search for stocks that have a low P/E ratio. The lower the metric, the less they have to pay per dollar of earnings. Companies that have a low P/E ratio but are otherwise solid companies can be a good investment because they are currently undervalued but the price is likely to increase in the future.
It is important to look at a company’s P/E in light of industry benchmarks. Industries affected by economic cycles tend to trade at much lower P/E compared to those that aren’t.
How to Use Price to Earnings to Evaluate a Company
The first step to using price to earnings to evaluate whether a stock is fairly valued involves finding companies that operate in the same field. Although finding a perfect match will always be a challenge, narrowing down the search to such things as geography or product and services is a good starting point.
The next step after finding comparable companies is adjusting earnings across the peer group. In this case, one ought to find out whether the comparable companies do use the same accounting methods such as inventory, revenue, and depreciation when it comes to calculating earnings. Adjustments should be made to achieve comparable earnings.
Once you have achieved comparable EPS, the next step is calculating the price to earnings ratio of the companies to be able to come up with the industry average. Once the industry average is ascertained, one can go forth and compare each company’s P/E to the industry average.
If a company’s P/E is slightly higher than the industry average, then it means that the market expects the company to continue outperforming the industry going forward. A company with a higher P/E will only be justified if it outperforms the market in key parameters such as future sales and EPS growth. A stock can be considered overpriced if the peer group comparison does not justify the high P/E.
If a company has a lower P/E than the industry, it may not necessarily mean that the company is unfairly undervalued. Instead, the same could mean that the market believes the company is struggling, hinting at possible underperformance in future.
Different industries come with different P/E benchmarks that one ought to consider when it comes to making a comparison. That said it is important to know when a sector or industry is overpriced before making an investment decision.
It’s been found that whenever the P/E ratio of all companies in a sector is above the historical average, then a major price correction may come into play sooner rather than later. Higher P/E across an industry can make it impossible for companies to live up to expectations when it comes to the generation of satisfactory returns for investors.
Difference between P/E and P/B
Price-to-earnings and price-to-book are two commonly used ratios regarding stock value. Price to book ratio is a ratio that compares a company’s market value to book value.
Book value refers to the company’s total assets minus total liabilities.
Price to book ratio underscores the value that market participants attach to a company’s equity. Companies command different P/Bs because some companies and industries are more efficient at producing income from their assets than others.
Price to book value differs from price to earnings ratio in the fact that it can be used to value firms with positive book values and negative earnings, i.e., companies that are making losses. P/E is only a useful measure for companies with positive earnings. However, P/B can be useless when used in companies with few tangible assets in their balance sheets, such as information tech companies that mostly offer services. In addition, the metric can remain negative for long periods should a company that has more debt than assets.
Price to Book ratio is ideal for analyzing stocks in industrials as well as in the financial sector. This is in part because these companies have a stronger link between assets and income generating ability. Industrial companies have assets tied to inventory and property, such as production plants or equipment. Property and loans on the other hand account for a huge chunk of assets owned by financial institutions.
Price to earnings ratio is a key financial metric for evaluating whether a stock is fairly valued. The fact that it standardizes stocks of different prices and earnings levels, call for its usage in combination with other metrics to ascertain the actual value of a stock prior to investing.
It is also important to note that a company with a high P/E ratio will always be under pressure to live up to market expectations. Investors expect such companies to register continuous earnings growth, and failure to do so always result in a stock price drop. It is for this reason that investors tend to be a little bit cautious when it comes to companies with a high P/E.
Conversely, just because a company has a lower P/E does not mean that its stock is a buy. In this case, it would be wise to do extensive research to determine why the company has a lower P/E before jumping into a trade. Low P/E at times reflects a lack of growth potential which could make it difficult for an investor to generate significant returns in the long term.
That said, the price to earnings ratio is not the only number worth considering when planning to buy shares. Some other things to look out for include dividend rate, price to book ratio, earnings charts as well as sales figures, among other fundamentals.