Price-to-Earnings Ratio Definition and Formula

FT Contributor  | 

The price-to-earnings ratio gets written in several different ways. Financial journalists and investors will refer to price-to-earnings or “P-to-E.” On websites and in investing publications, you may see terms like “PE ratio” or “P/E ratio.”

All these titles refer to the same thing: the price per share of stock compared to the earnings per share (which often gets abbreviated as EPS).

The P/E ratio comes in different forms, and investors use these various forms to look at the past performance of a stock, assess its current financial situation, or forecast future price movements.

Alone, the price-to-earnings ratio cannot predict the movement of a stock. However, it is a vital figure for any investor who is performing a fundamental analysis of a publicly held company’s financial performance.

How Is P/E Ratio Used?

There is no rule for finding a “good P/E ratio.” In fundamental terms, the P/E ratio is the amount that investors are willing to pay for each dollar of company earnings. For example, if the P/E ratio is 10, then investors are willing to pay $10 for every $1 of company earnings.

A higher price-to-earnings figure means more demand, which could be a good thing (investors expect the stock to rise) or a bad thing (the market already overvalued the stock). Likewise, a low P/E ratio could indicate sluggish performance, or it could be a sign of a mature company that achieves slow but always consistent growth.

When working on the fundamental analysis of a company, investors can decide which other figures to consider based on the P/E ratio. They may look at cash flow, past return-on-investment-capital data, sales figures, or equity numbers, for example.

Momentum investors and those with higher risk tolerance may look for different P/E ratios than value investors who are seeking reliable but undervalued companies. They also look at P/E ratios in different time frames or compare a company’s price-to-earnings numbers to competitor P/E ratios or an average P/E for the industry.

P/E numbers can also mean different things for different types of stocks. In some industries, a good P/E ratio is more than 30, while in other industries, a P/E of 30 would be an anomaly, and P/E in the 15 range might be considered good.

The P/E Ratio Formula

A P/E ratio has two components: share price and earnings per share (EPS).

P/E ratio = Price / EPS.

The price of a stock is self-explanatory, though you will want to choose the correct price data depending on the time frame on which you are working.

Earnings per share, or EPS, is a bit more complicated. It is a hypothetical number. If all of a company’s profits were distributed to shareholders, how much would each share get? The amount that each share would get is the EPS. In other words, the EPS is the net income of a company divided by the number of outstanding shares.

        EPS = income / number of shares.

EPS comes in different forms. You can average the previous 12 months (usually called “trailing twelve months” or TTM) of EPS figures. Some investors also look at hypothetical EPS figures for the future, which is known as the forward EPS.

It’s helpful to know how to calculate these figures. However, since both the P/E ratio and EPS are essential for investors, you can often find them listed in various forms on finance sites.

Examples

If the P/E ratio of a company is between 20 and 25, it means that investors are willing to pay anywhere between $20 and $25 on a stock for every $1 the company earns. However, there are industries where average P/E ratios are significantly higher or lower. In some growth industries, such as tech sectors, price-to-earnings figures can be much higher.

For the following examples, the P/E ratio involves data from the previous year (trailing 12 months or TTM).

Amazon (AMZN) provides an example of a stock with a very high P/E ratio.

Currently, the P/E ratio for AMZN is 82.58.

P/E ratio = price ($1,864.72) / EPS (22.58) = 82.58

General Motors (GM), on the other hand, is an example of an established company with a low P/E ratio. GM currently has a P/E ratio of 5.79.

P/E ratio = price ($35.80) / EPS (6.2) = 5.79

Types and Variations of the P/E Ratio

The P/E ratios in the previous examples use data from the trailing twelve months (TTM). There are different kinds of P/E ratios that offer different insights into a company and its stock. Some of these involve past performance, while others use different fundamental financial data to predict future P/E ratios.

Though the variables and comparisons may differ, all P/E ratios use a similar formula.

Absolute P/E

The absolute P/E ratio is the current stock price divided by the most current EPS data. The goal of this type of P/E ratio is to give an accurate picture of the price-to-earnings for the current period. When financial sites list a P/E ratio without any additional explanation, it is usually the absolute P/E.

A variation of the absolute P/E involves using six months of historical EPS numbers averaged with six months of estimated future EPS numbers.

Relative P/E

The relative P/E ratio compares the current (or absolute) P/E ratio with past P/E ratios. This figure gives investors a context in which to evaluate the current P/E ratio. Is it higher or lower than past ratios? Are there signs of consistent growth, or is the current P/E ratio an anomaly?

You arrive at the relative P/E by dividing the current P/E by a past P/E figure. The answer will give you the amount of change in P/E over the given time period.  

P/E 10

P/E 10 uses the current price for its equation, but it uses an average EPS from the past 10 years. Rapid changes in the market or business cycle can cause absolute price-to-earnings ratios that do not offer an accurate picture. A P/E 10 ratio provides a more accurate view of long-term performance by giving less weight to current anomalies.

P/E 30

The P/E 30, like the P/E 10, uses a long term average of the EPS in its equation. In this instance, however, the EPS gets averaged out over 30 years. This number gauges the long-term value of a stock, which you can then compare to its current performance. Some investors use this long-term figure to look at the current state of an index or an associated index fund.

Forward P/E

The forward P/E uses estimated projected earnings in its equation. This figure can be relevant for forecasting stock moves. However, the future EPS is just an estimate. Still, though, major financial sites that investors use to get data for their fundamental analysis of stocks often publish such EPS estimates. Investors use the current stock price with these future EPS numbers to solve the forward P/E equation.

Trailing P/E

The trailing P/E uses historical data to solve the price-to-earnings equation. Most commonly, the trailing P/E uses the past 12 months of EPS data and the current stock price. Some investors prefer this number to the forward P/E because they do not have to rely on someone else’s estimate for future EPS. They think that the trend of the past 12 months provides enough insight into the state of the company, and they can see if the pattern of the trailing P/E fits with the numbers from the forward P/E.

How to Interpret P/E Ratio

P/E ratios may mean different things to different types of investors. In some cases, a high P/E ratio is a sign of rapid growth and increased interest from investors. Investors who are looking to invest in rapidly rising stocks prefer higher P/E ratios. Some investors see P/E ratios above 30 as a sign that such a company is on the way up.

A high P/E ratio can also be a sign of increased risk. The price is rising faster than earnings, so investors could be overvaluing the company. There is no sure way to tell if this is the case until demand falls and the stock price plummets.

Momentum investors may avoid stocks with low P/E ratios because a smaller number (below 15) may be a sign of slow growth. Other investors, however, gravitate towards low P/E ratio stocks because they may offer value. Many established companies have low or moderate, but very consistent, P/E figures.

P/E ratios can help investors make assumptions about stocks. However, they usually need to use additional information and financial data to get a complete picture and make predictions about future price movements.

Related and Alternative Measurement

Investors use other related equations instead of a price-to-earnings ratio, or as a tool to compare and confirm assumptions based on the data.

Earnings Yield

The earnings yield is the inverse of the price-to-earnings ratio. It is the EPS divided by the stock price. The figure can help investors measure the rate of return for their investment. It can tell them how long they have to wait to get a return on their investment, or, in other terms, how much return they can expect from every dollar that they invest.

PEG Ratio

A price-to-earnings-growth ratio, or PEG ratio, measures expected growth. To arrive at this figure, you divide the P/E ratio by expect earnings. Investors use this figure to decide if a stock is overvalued or undervalued. This calculation may be significant for high P/E stocks because it can help investors see whether the high P/E is because of actual growth potential or if it is just overhyped.


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