The price-to-earnings ratio, commonly known as the P/E ratio, is one of the most widely used valuation metrics. It is a basic measure used to compare different investments or the same investment over different periods of time, and it’s simple to calculate.
The P/E ratio is most commonly used for a quick comparison between two securities to see how Wall Street values them, with a higher P/E suggesting that future earnings are more likely. Dividing the common stock market share price (numerator) by earnings per share (denominator) produces the ratio. For example, a stock with a market price of $15.00 and earnings of $1.00 per share would have a P/E ratio of 15 (15/1=15).
P/E ratios can be calculated on past or realized earnings, projected earnings, or a combination of each. Earnings are sometimes adjusted to exclude extraordinary events, since they are unlikely to repeat. When considering P/E ratios, it is important to understand if and how earnings have been adjusted and whether they are actuals or projections.
Examples of different P/E types include:
- Trailing or Current P/E. Analysts use earnings for the most recent 12-month period. As each quarter is completed, the oldest quarter’s earnings per share is dropped and the most recent quarter is added to the total.
- Projected or Forward P/E. The divisor is the projected or estimated earnings per share over the next 12 months. The estimate may be that of a single analyst or the consensus estimate from a group of analysts. It is important to know the identity and qualifications of the analysts providing an estimate to determine whether it is realistic.
- Combined or Mixed P/E. Some analysts use a combination of the two last quarters of actual earnings plus the first two quarters of projected earnings as the divisor.
Regardless of which type of P/E you use, it’s important to be consistent when comparing period to period or one company’s stock with that of another. Since analysts have broad discretion in choosing what numbers they use to calculate P/E ratios, you should not be surprised that the ratios commonly vary from analyst to analyst or firm to firm. Be careful that you don’t compare apples to oranges.
Interpretations and Usage of the Price-to-Earnings Ratio
Simply stated, the P/E is an indication of how much investors at a particular moment in time are willing to pay for each dollar of a company’s earnings. The average P/E for stocks since 1900 has been around 15.
Companies that grow faster than average generally enjoy higher price-to-earnings ratios (greater than 15), a reflection that investors are willing to pay more per dollar of earnings today because they expect future earnings growth to exceed that of other companies. For example, a company with a P/E ratio of 30 would theoretically earn at double the growth rate of a company with a P/E of 15. Conversely, a company with earnings growth expected to be less than average would have a lower P/E ratio (less than 15).
A common use of P/E ratios by investors is deciding which company in an industry to purchase. For example, if two companies have the same projected earnings per share, but Company A has a lower P/E than Company B, the investor will likely choose Company A. This choice is based upon the presumption that the market has overlooked Company A and, as earnings are achieved, its P/E ratio will rise to the P/E level of Company B.
Of course, the P/E ratio of Company B could contract to that of Company A instead. The decision to buy Company A rather than Company B would still be valid since the price of Company B would fall, reflecting the lower P/E.
Limitations of the Price-to-Earnings Ratio
While P/E ratios are popular and useful metrics by which to compare alternative security investments, they are best used as general indicators of value. Price-to-earnings ratios, due to their simplicity, have inherent limitations as an analytical tool:
- Market Prices in the Short-Term Can Be Erratic. Short-term prices in the market are driven by emotions triggered by rumors and expectations. As a consequence, P/E ratios can get out of whack from time to time until facts and logic return to the investing public. Be sure that you consider the ratio over a period of time to reduce the variability resulting from unwarranted euphoria or fears.
- Reported Earnings Are Frequently Managed. Company CEOs and CFOs are aware that consistent, expected performance is generally rewarded with a higher ratio than erratic, unexpected results, even if positive. For this reason, management often seeks to level reported earnings by making accounting decisions that optimize them to meet investor expectations.
- Abnormally High Growth Rates in Earnings Cannot Be Sustained Indefinitely. The impact of compounding is often overlooked as companies grow and mature. High growth rates attract competitors, which tends to reduce margins for an industry as a whole. As companies mature, growth rates tend to level out, reflecting the intensity of competition, cultural changes, and the complexity of managing a larger, multi-tiered organization. Ratios that are abnormally high tend to contract over time, primarily because the projected earnings are eventually announced or the stock price falls when earnings disappoint.
- Extraordinary Events Can Distort Future Expectations. Market leaders that have higher P/E ratios have shown an ability to constantly reinvent themselves, introducing a series of revolutionary products year after year. On the other hand, some companies gain market attention with a single product but are unable to sustain their advantage over time. Others may suffer unexpected losses due to external causes (such as new regulations or an industrial accident) and never recover. At the same time, some companies weather the storm and regain their vigor. Investors tend to “brand” companies based on their past rather than their future so that P/E ratios may not reflect the true value of the firm. The difficulty for many investors when analyzing P/E is deciding whether the ratio is or isn’t justified by probable future earnings.
- Early-Stage and Natural Resources Companies Can Give Mixed Signals. Emerging and early-stage companies often spend heavily in their first years to capture market share, build infrastructure, or develop customer recognition. As a consequence, their earnings are delayed or restricted. In many cases, they report losses for years before breaking into a fast-growing stream of profits. The use of a P/E doesn’t help to evaluate a company like Amazon (625 P/E) or Facebook (107 P/E). Similarly, the results of natural resources companies do not reflect the growth of assets and earnings that are delivered over several years. The expense of discovery is often deducted, rather than capitalized, possibly producing accounting losses and no profits.
- The Impact of Debt Is Overlooked. The value of a company is its combination of equity and debt. Leverage increases potential profit or loss, while price-to-earnings ratio considers just the equity value of a firm, not the total value of debt and equity combined. A company with a significant proportion of debt to total value carries more risk than a company with no debt.
- P/E Ratios Can Be Difficult to Interpret. A low P/E can mean that a company’s worth is undervalued by the market in the short-term and represents a buying opportunity for an astute investor. It can also mean that the company is expected to have problems in the future and smart investors have dumped the stock to avoid probable losses. Using P/E ratios alone for investment decisions is a risky and unwise practice.
Price-to-earnings ratios are quick and easy to calculate. They are particularly useful in making immediate comparisons and superficial analysis if you grasp the underlying logic of the calculation, as well as its limitations. P/E ratios should also be used with other metrics to confirm your analysis before taking action.
Have you used P/E ratios in your investment analysis?