P/E Ratio or Price-to-Earnings (P/E) Ratio

The P/E ratio compares a company's share price to its earnings per share (EPS). The P/E ratio, often known as the price or earnings multiple, helps to determine the relative value of a company's stock. It's useful for comparing a company's valuation to its previous performance, other companies in its industry, or the entire market.

P/E ratios can be estimated either trailing (backward-looking) or ahead (projected).

P/E Ratio Formula and Calculation

P/E Ratio=Earnings per share/Market value per share​

Simply look for a stock's ticker on a credible financial website to see its price (P). Although this real value shows what investors are now paying for the stock, the EPS is based on earnings reported at different periods.

EPS is typically given in two ways. Trailing 12 months (TTM) refers to the company's performance over the previous 12 months. Another is found in earnings reports, which frequently include EPS guidance. This is the company's outlook for future earnings. These various variations of EPS serve as the foundation for trailing and forward P/E.

Source: Investopedia.com

Understanding the P/E Ratio

Analysts interested in long-term valuation patterns can use the P/E 10 or P/E 30 ratios, which average earnings over the previous ten or thirty years. These measures are often used when trying to gauge the overall value of a stock index, such as the S&P 500 because these longer-term metrics can show overall changes through several business cycles.

Since 1927, the S&P 500's P/E ratio has ranged from 5.9 in mid-1949 to 122.4 in mid-2009, shortly after the financial crisis. The long-term average P/E for the S&P 500 index is around 17.6, implying that the index's stocks have been collectively priced at more than 17 times their weighted average earnings.1 This average can be used to determine whether the market is valued higher or lower than historical norms.

Forward Price-to-Earnings

The forward and trailing P/E ratios are the most widely employed. A third, less common form adds the last two actual quarters and the estimates for the next two quarters.

The forward (or leading) P/E ratio is calculated using future earnings forecasts rather than trailing numbers. This forward-looking metric, also known as "estimated price to earnings," helps compare current earnings to future earnings and can provide insight into what earnings would look like without revisions and other accounting adjustments.

However, there are issues with the forward P/E statistic, such as corporations underestimating earnings to beat the predicted P/E when the next quarter's results are released. Furthermore, outsider analysts may make estimates that differ from the company's estimates, confusing.

Trailing Price-to-Earnings

The trailing P/E ratio is calculated by dividing the current share price by the cumulative EPS for the preceding 12 months. It is the most widely used P/E metric since it is regarded to be objective—assuming the company's earnings were reported correctly. However, the trailing P/E has limitations, such as the fact that a company's past success may not always predict future earnings.

Investors frequently make purchasing decisions based on projected earnings rather than actual results. Using the trailing P/E ratio might be problematic because it is based on a fixed earnings per share (EPS) figure, whereas stock prices fluctuate. This means that if something substantial changes a company's stock price, whether positively or negatively, the trailing P/E ratio will not appropriately represent it. In essence, it may not provide an accurate view of the company's current valuation or prospects.

Because earnings are only published quarterly, the trailing P/E ratio will fluctuate as the price of a company's shares changes. Stocks trade whenever the market is open. As a result, some investors prefer forward price-earnings. Analysts predict earnings to rise if the forward P/E ratio is lower than the trailing P/E ratio, and to fall if the ahead P/E is higher than the current P/E ratio.

Examples of the P/E Ratio

Let's use FedEx Corporation (FDX) as an example. We may determine FDX's P/E ratio as of February 9, 2024, when the stock closed at $242.62. The company's trailing 12-month profits per share (EPS) were $16.85.

Therefore, FDX's P/E ratio was as follows:

$242.62 / $16.85 = 14.40

Comparing Companies Using P/E

Let's look at two energy firms and compare their values.

Hess Corporation (HES) has the following information at the end of February 9, 2024. We'll use the diluted EPS to account for what would happen if all convertible securities were exercised.

• Stock price: $142.07

• Diluted 12 months trailing EPS: $4.49

• P/E: 31.64 ($142.07 / $4.49)

HES thus traded at approximately 31 times trailing earnings. However, the P/E ratio of 31 is meaningless unless you have something to compare it to, such as the stock's industry group, a benchmark index, or HES's historical P/E range.

The P/E ratio of HES was greater than that of the S&P 500, which was approximately 22 times 12-month trailing earnings as of February 9, 2024. To compare HES's P/E ratio to a peer, we'll look at Marathon Petroleum Corporation (MPC).

• Stock price: $169.97

• Diluted 12 months trailing EPS: $23.64

• P/E: 7.19

When you compare HES's P/E of 31 to MPC's of 7, HES's stock may appear significantly expensive in comparison to the S&P 500 and MPC. Alternatively, HES's higher P/E ratio may indicate that investors predict significantly better profit growth in the future than MPC.

However, no ratio can provide all of the information you need about a stock. Before investing, it is prudent to employ a variety of financial instruments to establish whether a company is reasonably valued.

Investor Expectations

In general, a high P/E ratio indicates that investors anticipate higher profit growth than those with a lower P/E. A low P/E ratio can imply that a company is either undervalued or performing particularly well in comparison to its prior performance. When a corporation reports no earnings or losses, the P/E ratio is denoted as N/A. It is conceivable to calculate a negative P/E ratio, but this is uncommon.

The P/E ratio can help standardize the value of one dollar of earnings across the stock market. In theory, by taking the median of P/E ratios across several years, one might create a standardized P/E ratio that could be used as a benchmark to determine whether a company is worth buying.

N/A Meaning

A P/E ratio of N/A indicates that the ratio is unavailable for the company's shares. A company's P/E ratio can be N/A if it is newly listed on the stock exchange and has not yet recorded results, such as in an initial public offering (IPO). It could also indicate that a corporation has zero or negative earnings.

Source: stockanalysis.com

P/E vs. Earnings Yield

The earnings yield is the inverse of the price-to-earnings ratio. The earnings yield is calculated by dividing the EPS by the stock price and expressing the result in percentage.

If Stock A is selling at $10 and its EPS for the previous year is 50 cents (TTM), it has a P/E ratio of 20 (i.e., $10 / 50 cents) and an earnings yield of 5%. If Stock B is selling at $20 with a TTM EPS of $2, it has a P/E ratio of 10 ($20 / $2) and an earnings yield of 10% ($2 / $20).

The earnings yield is less commonly utilized than the P/E ratio. Earnings yields are important if you are concerned about the rate of return on your investment. For equity investors who receive regular investment income, this may be a minor worry. This is why many investors may choose value-based metrics such as the P/E ratio or stocks.

Earnings yield is also useful when a corporation has no or negative earnings. Because this is frequent in high-tech, high-growth, or startup companies, EPS will be negative and reported as an undefined P/E ratio (N/A). If a corporation has negative earnings, it will have a negative earnings yield, which can be used to compare.

P/E vs. PEG Ratio

A P/E ratio, even when derived using a forward earnings forecast, does not always indicate if the P/E is appropriate for the company's anticipated growth rate. To solve this, investors use the price-to-earnings-growth ratio, or PEG.

The PEG ratio calculates the relationship between the price/earnings ratio and earnings growth to provide investors with a comprehensive picture. Investors use it to determine if a stock's price is overvalued or undervalued based on earnings and the company's predicted growth rate. The PEG ratio is determined by dividing a company's trailing price-to-earnings (P/E) ratio by its earnings growth rate over a specified period.

PEG is typically considered more insightful than the P/E ratio because it takes into account both trailing earnings and anticipated earnings growth. For example, a low P/E ratio may indicate that a company is inexpensive and worth purchasing. However, using the company's growth rate to calculate its PEG ratio may reveal a different narrative. PEG ratios can be classified as "trailing" or "forward" based on previous or predicted growth rates.

Although earnings growth rates vary by sector, a stock with a PEG of less than one is generally regarded as undervalued because its price is low in comparison to its predicted profit growth. A PEG larger than one may be considered expensive because it indicates that the stock price is excessively high about the company's predicted profit growth.

Absolute vs. Relative P/E

Analysts distinguish between absolute and relative P/E ratios in their analyses.

Absolute P/E

The numerator of this ratio is typically the current stock price, while the denominator can be trailing EPS (TTM), predicted EPS for the next 12 months (forward P/E), or a combination of trailing EPS from the previous two quarters and forward P/E for the next two quarters.

When distinguishing between absolute and relative P/E, keep in mind that absolute P/E indicates the current period's P/E ratio. For example, if the current stock price is $100 and the TTM earnings are $2 per share, the P/E ratio is 50 = ($100 / 2).

Relative P/E

The relative P/E compares the absolute P/E to a benchmark or a range of previous P/Es over a specific period, such as the last ten years. The relative P/E indicates what proportion or percentage of previous P/Es the current P/E has achieved. The relative P/E normally compares the current P/E number to the greatest value in the range. Investors may also compare the current P/E to the lower end of the range, determining how close it is to the historical low.

If the current P/E is lower than the previous figure (high or low), the relative P/E will be less than 100%. If the relative P/E metric is 100% or above, it indicates that the current P/E has equaled or surpassed the previous value.

Limitations of Using the P/E Ratio

Like any other fundamental indicator, the price-to-earnings ratio has some limits that must be understood. Companies that are not profitable and have no or negative earnings per share make calculating P/E difficult. Analysts have differing views on how to cope with this. Some claim a negative P/E, some a zero P/E, and the majority just state that the P/E does not exist (N/A) until a company becomes successful.

The primary limitation of using P/E ratios is comparing the P/E ratios of companies from various industries. Companies' valuations and growth rates vary greatly across industries according to how and when they make their money.

As a result, P/E should only be used as a comparative tool when comparing companies in the same industry, as this is the only type that produces meaningful results. For example, comparing a telecommunications company's P/E ratio to that of an oil and gas drilling company may suggest that one is a better investment, but this is not a valid conclusion. An individual company's high P/E ratio, for example, would be less concerning if the entire sector had high P/E ratios.

Other P/E Considerations

Because a company's debt can have an impact on both share price and profitability, leverage can also skew P/E ratios. For example, imagine two similar companies that have different debt levels. The corporation with greater debt is likely to have a lower P/E value than the one with less debt. However, if the business is strong, the one with the most debt may have higher earnings due to the risks it has taken.

Another important constraint of price-to-earnings ratios is found in the formula for calculating P/E. P/E ratios are based on accurately representing the market value of shares and earnings per share predictions. The market decides the prices of shares offered in many locations. However, the corporation itself provides earnings statistics. Thus, it is likely that it will be manipulated, so analysts and investors must rely on the company's officers to supply accurate information. If that trust is shattered, the stock will be regarded as more risky and less valuable.

To mitigate these risks, analysts analyze only one measurement: the P/E ratio. If a corporation purposefully manipulated its results, it would be difficult to ensure that all metrics were adjusted consistently. That is why the P/E ratio remains a key data point when examining public firms, albeit not the only one.

Source: smallcase.com