What is the PE ratio?
Abbreviated as PE ratio, the Price to Earnings Ratio refers to the share price of a stock to its earnings per share (EPS). PE ratio is widely used to evaluate stocks as it gives a clear picture of whether the current market price of a stock is cheap or expensive.
The idea behind the PE ratio is to help shareholders understand a company's value. It reveals the market expectation alongside the amount one must pay per unit of current earnings as well as future earnings.
It is important to understand a company's earnings before investing in it. Such information helps an investor to know the current profitability of the company and projected future profitability. Additionally, in a situation where the company does not grow while earnings remain the same, the PE ratio can inform how long the company would take to pay back the amount used to buy each share.
How to calculate the PE ratio?
The formula for PE is market value price per share/company's earnings per share
Let's break these down further for better understanding:
1. Market value price per share
This is the price of acquiring a share of a company's stock in the marketplace, like the stock exchange. The price is not constant. Instead, it varies all day long based on numerous factors like stock demand.
The market value price per share increases whenever there is a high number of investors seeking to buy compared to those selling stock. Conversely, the price declines when the demand is lower than the supply.
Value investors normally pay close attention to market value price per share. The information assists them in knowing when to buy shares at a reasonably low price. Similarly, company treasurers track this information which is needed for justifying new stock issuance when the price is too high.
Different factors are involved when it comes to market value price per share. Some of these factors include:
- Whether there is a stock buyback program
- The income reported by issuing company
- The issuing company's cash flow
- Future prospects of the issuing company as perceived by investors
- Future prospects of the issuing company's industry and the economy in general
Most people often make the mistake of comparing the market value per share of two different companies. For instance, if Company XYZ trades at $10 per share while Company ABC trades at $1 per share, it may seem that XYZ is more valuable than ABC. However, the stock prices may tell you an entirely different story. The best way to compare the market value of two companies is to use market capitalization.
2. Company's earnings per share
Earnings per share of a company refer to its profits divided by the outstanding shares of its common stock. The result reveals how profitable a company is. Most companies normally report their EPS as an adjusted item for potential share dilution and extraordinary items.
A company is said to be more profitable if it has a higher EPS.
The formula for calculating Earnings per share is as follows:
Earnings per share = (Net Income – Preferred Dividends) / (End-of-Period Common Shares Outstanding)
The balance sheet and income statement provide information related to period-end common shares outstanding, net income or earnings, and dividends paid on preferred stock. Since the number of shares changes over time, using the weighted average number of common shares provides accurate results.
While calculating weighted average outstanding shares, it is paramount to factor in stock dividends or splits. You can make the calculation simpler by using the number of shares outstanding at the end of the period.
Earnings per share is a very important metric because it is used to measure a company's profitability. It is used to measure the PE ratio, where the E in the ratio represents EPS. An investor who divides a company's earnings per share with the stock value gets to see the market's willingness to pay for each dollar of earnings.
Additionally, EPS is an important indicator for picking stocks. Individuals that trade or invest in stocks often have to select a broker that matches their style. In such a case, the investor will compare earnings per share with the share price of the stock to see earnings value and the investor's perspective on growth.
PE ratio analysis
If you want to find out whether a stock is overvalued or undervalued, you need to compare it with other stocks in the industry group or sector. Different industry groups make up a sector, while an industry group comprises stocks with similar businesses like financial services or banking.
Industry groups are not always beneficial. Instead, particular business cycles will favour the operations of the group. As such, professionals typically focus on the industry group when it is their most opportune moment.
Keep in mind that the PE ratio calculates expected earnings. A maturing economy is characterized by a rise in inflation. Thus, the Federal Reserve tames the rapid rise in prices by increasing interest rates to tame the economy.
Even under such tough measures by the Federal Reserve, there will be some sectors performing better. For instance, banks and financial institutions will make more money from the interest rates as they offer products such as mortgages and credit cards. Also, companies operating in the energy sector witness increased earnings because they get to charge more for commodities.
On the other hand, as the economic recession nears completion, interest rates reduce, and banks' revenue reduces. At the same time, cyclical consumer stocks register an increase in earnings since more consumers can buy on credit under low rates.
The PE ratio for stocks in a certain industry can rise under specific scenarios. Investors should understand the existing cycle to know which companies would make money during the existing circumstances. At the same time, they should look at companies that have the lowest Pes to know if they are undervalued.
The negative PE ratio explained
There are times when the PE ratio of a company could fall into the negative. That happens in cases where there were no earnings during a given period, or the company had a loss. As a result, the EPS would be a negative number.
Since the EPS is negative and it is a denominator in computing the PE ratio, the final value could be negative.
Rather than companies indicating their PE ratio as negative, they typically report it as N/A. Investors also keep using N/A or 0 until when the company gets a positive EPS.
Trailing PE ratio
The trailing PE ratio is calculated from earnings per share of stock during a 12-month period as opposed to considering future projections.
Using this approach is more objective, considering that the computation is based on already recorded figures instead of going for predictions. It aligns well with the needs of cautious investors who may not be quick to go with whatever analysts say or companies publish.
Nonetheless, the trailing PE ratio has its fair share of limitations. For instance, past earnings may fail to correlate with future earnings.
Is the PE ratio always reliable?
When using the PE ratio, you should also know that it has its fair share of limitations. Whereas the first part of the calculation is straightforward, getting the appropriate earnings number can prove challenging. Investors have difficulty defining earnings and factors that impact the same. Such factors prove to be the most limiting elements of PE ratio computation. They include:
- Volatile market prices – The PE ratio can be thrown entirely off in situations of volatile market prices
- Earnings growth – These are excluded from the PE ratio. Thus, the PE ratio does not share much information with investors regarding EPS growth prospects. When a company is growing rapidly, the investor can comfortably buy it at a high PE ratio with the expectation that faster earnings will lower the PE. On the other hand, when earnings are growing slowly, the investor may be triggered to look elsewhere for stock that has lower PE. In other words, investors cannot determine whether a high PE is linked to an overvalued stock or expected company growth.
- Earnings components of a company – The PE ratio makes it difficult to determine this element, given that it is often calculated from trailing earnings or historical earnings. Historical earnings do not always reveal helpful information about future earnings, making them of little use to investors. Investors are mainly interested in future earnings or forward earnings, which are based on financial analysts' opinions.
- Cross-industry comparison – The PE ratio cannot be used to compare companies operating in different industries. That makes it necessary to consider alternative measurements.
As seen above, the PE ratio has its fair share of limitations. For instance, it fails to give a clear picture of the company's growth rate. Some people may assume that using forward earnings estimates can overcome this limitation, but that is not the case. The simplest way to address the PE ratio limitation is to use the PEG ratio.
The price/Earnings-to-Growth (PEG) ratio is a measure of how the price/earnings ratio relates to earnings growth to give investors complete information that the PE ratio may have failed to reveal.
With the PEG ratio, an investor can determine whether or not a stock has been undervalued or overvalued, as well as show the expected growth rate of the company.
The PEG ratio is important because not only does it determine stock value, but it also shows information about expected company growth. It is calculated as follows:
PEG Ratio = (Price/EPS)/EPS Growth
The details needed to calculate the PEG ratio can be obtained from the PE ratio of the company. PE ratio is calculated by dividing price per share by earnings per share, whose information is available from the income statement and balance sheet.
After getting the PE ratio, compute the expected growth rate for the stock under consideration. That can be done using information from financial websites that track the stock. Consolidate your figures and get the PEG ratio.
The level of accuracy for the PEG ratio is dependent on the inputs used. If your source of data for this computation is a published source, ensure that you know the growth rate used. For instance, you would get an inaccurate PEG ratio if it is calculated using historical growth rates. The ideal approach is to calculate using one-year, three-year, or five-year expected growth rates.
The PE ratio of a company is an important metric when evaluating whether the stock of a company is overvalued or undervalued in comparison to its earnings. The ratio reveals what the market would be willing to pay as per the present operations and the prospects of growth. It is essential that every investor masters how to compute the PE ratio so that they make informed investment decisions.