What is the P/E ratio?
The price-to-earnings (P/E) ratio calculates the current share price of a company relative to its earnings per share (EPS). The P/E ratio indicates how investors assess a company’s performance, specifying how much they are prepared to pay for one rand (R1) of a company’s earnings or profit.
The earnings per share of a company indicates its profitability and is calculated by dividing the company’s net income with the total number of shares outstanding.
The formula to calculate the P/E ratio is to divide the share price with the earnings per share. For example, if company PDS reports an EPS of R1.50 and its stock is selling for R30 per share, the P/E ratio is R20 (R30 per share divided by R1.50 earnings per share).
Put differently, the P/E ratio is a comparison of how investors feel about a company (its share price), and how well the company is actually performing (its EPS).
The P/E ratio is also referred to as the price multiple or the earnings multiple.
Short history of the P/E ratio
Benjamin Graham, called the ‘Father of value investing,’ was in the 1920s one of the earliest promoters of value investing, which is about finding shares that are worth more than their current share price. He promoted the trustworthiness of the P/E ratio as one of the easiest and fastest methods to determine if a stock of a company is trading on a fundamentals-based value or a speculative basis.
His value investing strategy is explained in his book, ‘The Intelligent Investor’ (published in 1949), under 7 value criteria, of which the P/E ratio is the fifth one. Some of his recommendations with regard to the P/E ratio is:
- ‘Invest in companies with price to earnings per share (P/E) ratios of 9.0 or less.’
- ‘Look for companies that are selling at bargain prices.’
What is the difference between the P/E ratio and the P/B ratio?
The price-to-book (PB) ratio, also known as the market-to-book (M/B) ratio, is used to calculate a company’s current market value in relation to its book value.
The market value is the current share price of all the outstanding shares of the company and the book value refers to the difference between the book value of assets and the book value of liabilities.
The formula to calculate the P/B ratio is:
P/B = Market capitalisation/Net book value.
Typically, the P/B ratio is used by investors to determine whether a company’s shares are valued properly. The higher the P/B ratio, the more expensive are the shares.
Using the P/E ratio
Investors use different accounting tools to determine the value of a company’s shares. The P/E ratio is one of these and one of the most common ways to determine whether a company’s share price is undervalued or overvalued.
It is a standard element of share analysis, also called stock analysis.
The P/E ratio of a company enables investors to compare it to:
- A company’s historical P/E ratio in order to evaluate its performance over a certain period of time, such as a financial year.
- The P/E ratios of competitors from the same industry. Different industries have different P/E ratio scales that are viewed as normal for the particular industry. Investors have different expectations for different types of businesses. For example, it is challenging to decide whether a company with a P/E ratio of 15x is a good investment without applying any comparisons.
The key benefit of the P/E ratio is that it standardises shares of different prices and levels of earnings.
There are two types of the P/E ratio:
- The forward P/E, also referred to as the leading P/E. A forward P/E ratio uses future estimates of earnings to provide a scenario of what earnings will look like, excluding possible changes and accounting adjustments. The leading P/E is also sometimes called ‘estimated price to earnings.’
- The trailing P/E uses the earnings per share (EPS) of previous periods.
The message of a P/E ratio
To interpret a P/E ratio as ‘good’ or ‘bad’ is difficult. In fact, there is no single ‘good’ P/E ratio because it is a comparison tool, not a yardstick.
It is difficult to apply a general rule. Although, it is helpful to evaluate a company’s P/E ratio in a broader context, such as the sector or industry in which a company operates. Comparing P/E ratios can be beneficial to discover much about a specific company.
High P/E ratio
Shares may be overvalued
A significantly higher P/E ratio than other similar companies, or even the company’s own previous P/E ratio, could be an indication that the company’s shares are overvalued.
For instance, if companies in a particular industry reflect P/E ratios between 20 and 30, and the P/E ratio of company ABC is above 35, could be an indication that its shares are overvalued.
Expectations of higher future earnings
A reason for the rise of a company’s P/E ratio is that investors expect a high level of earnings in the future, and that growth will be strong. The shares of a company with a high P/E ratio are considered ‘growth shares’, also called ‘growth stock’.
The share price has increased faster than earnings, on expectations of improved performances or new products or services.
Growth stocks are often higher in volatility and will more likely be viewed as a risky investment.
Low P/E ratio
Shares may be undervalued
A low P/E ratio may indicate that a company’s share price does not correctly reflect its true value, based on its earnings.
The share price may remain the same while the company’s earnings increase, causing a lower P/E ratio. Investors may consider the shares as value shares (value stock), providing an opportunity to buy the shares with the assumption that the price will increase in the future to correspond to the rise in earnings.
Earnings may be incorrect
There may be various reasons for this to happen. For example, missing earnings targets or misrepresenting earnings. This may also be an indication that a company is in financial trouble.
In this case, investors may fear the share price will stay low without expectations for future company growth.
Some limitations of the P/E ratio
The P/E ratio is a valuable tool to analyse the value of a company’s shares. However, it also comes with its own limitations, such as, to name but a few:
- Companies that are not profitable or have negative earnings per share, present a challenge when calculating their P/E ratios.
- Typically, earnings per share (EPS) is based on data from the past. It can be an indication of a company’s future performance but is by no means a certainty. Put differently, past performance does not guarantee future results.
Note: This article does not intend to provide investment or trading advice. Its aim is solely informative.
Frequently Asked Questions
What is the average P/E for S&P 500?
Historically it has ranged from 13-15.
What is P/E ratio?
See our article Price-to-Earnings Ratio explained for Dummies.
What does a negative P/E Ratio mean?
It means that the company has negative earnings or is losing money.
What is EPS?
A company’s earnings per share.
How do you use P/E ratio?
Take the current share price and divide that by the company’s earnings per share.
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