The P/E ratio, also known as the price to earnings ratio, is the method of valuing a company by dividing its share price by the company’s earnings per share. It’s a common way to determine if the market is overvaluing or undervaluing a company.
You won’t need to manually calculate the price to earnings ratio yourself. This information is readily available online. Most brokerages will have the P/E and many other indicators/valuations for just about every company that’s publicly traded.
Different versions of P/E
- “Trailing P/E” uses the average number of common shares divided by the net income for the most recent 12-month period. It is the most common meaning of “P/E” unless specified otherwise.
- “Trailing P/E from continued operations” excludes earnings from one-off windfalls, discounted operations, write-downs, accounting changes, etc and only uses operating earnings.
- “Forward P/E” instead of the company’s current net income, forward P/E uses estimated earnings over the next 12 months. Estimates usually come from the mean estimations published by a group of analysts.
What makes the P/E Ratio Important
So what is the importance of a stocks P/E ratio? Earnings are important because investors want to know how profitable the company is. They also want to know if the company will be profitable in the future. If a company has a P/E ratio of 10, that means investors are paying $10 for every dollar of the company earnings. This is why it is sometimes referred to as the “multiple.”
The P/E ratio can be also interpreted as how long the company would need to sustain its current earnings in order to pay back its current share price. That means with a ratio of 10, it will take 10 years for the earnings to add up to your purchase price. It’s important because it allows the investor to get an idea of how a company is being priced by the market. A higher P/E means investors are paying more per dollar of a company’s earnings, and it will take more time for them to earn enough to pay the investor back.
You should compare a company’s P/E to similar companies in its industry.
To get a better idea if the company is over or undervalued it is essential to compare the ratio with other similar companies within the same industry. If you are to look at the P/E without comparing it to other similar companies, it won’t do you much good. Different industries and sectors will have higher or lower P/E ratios. For instance, tech companies will generally have a higher P/E than say those who are in the food industry.
Factors that might contribute to a high P/E ratio
- Investors are enthusiastic about the company and its future
- Wide economic moat, making the company an industry leader
- Higher growth potential
- Stable profits with high expectations of the company’s capability to consistently beat future earnings
Typically, stocks are overvalued if they are trading significantly above their historical PE ratios or their industries average PE ratio.
Factors that might contribute to a low P/E ratio
- Unable to determine the company earnings
- The company is losing money or has negative earnings per share
- Low or negative growth potential
- Poor corporate practices or management lacks credibility
If stocks are trading below their historical PE ratios or their industries average PE, it is generally considered to be undervalued.
Try not to rely solely on the P/E ratio
After reading this, you should understand the importance of the P/E Ratio. However, it is not the only factor one should consider when picking a stock. If a company has a low P/E it doesn’t automatically mean it’s undervalued and that you should buy it. And vice versa with a high P/E ratio. It’s always worth the time to investigate the company’s other fundamentals. One must also consider the current market conditions and economic outlook.