What IS PE RATIO?
The price-to-earnings ratio, or PE ratio, is used to evaluate the current stock price of a company relative to its earnings per share. Price-to-earnings ratio evaluation is one of the most commonly used stock screening methods.
The PE ratio of a stock serves as a barometer to identify that a company’s prevailing market price accurately reflects its earnings potential when compared to that of peers or a benchmark index.
Calculating the Price-to-Earnings Ratio
The price-to-earnings ratio can be calculated using the following formula:
PE ratio = market value per share divided by earnings per share
To calculate the PE ratio of a given stock, simply divide the most recent stock price by earnings per share (EPS), information that is readily available and reported to shareholders on a regular basis.
As an example, if the current stock price of a company is $50 and its EPS is $4, the ratio would be 50/4, or 12.50. What this means for investors is that, given the current earnings per share, it would take twelve and a half years to recover the cost of an investment of $50.
The PE ratio cannot be negative. If a company is incurring losses, its PE ratio cannot be computed. You may see this reported as a ratio of N/A.
Like many other stock performance metrics, PE ratio isn’t static. Stock prices fluctuate constantly, so price-to-earnings ratio also changes over time. Changes in reported earnings or future earnings projections of the company also cause the PE ratio to change.
Key PE Ratio Variations
When calculating a price-to-earnings ratio, the current price component can be easily obtained from financial websites or your stockbroker. It is important to note, however, that the earnings component of the equation can differ based on an investor’s interest in past earnings or expected future earnings. These differences produce three main types of PE ratio calculation.
Trailing PE Ratio
This PE ratio uses the trailing twelve months (TTM) earnings of a company in the denominator of the price-to-earnings equation. TTM earnings represent recording earnings for the last year. Since these earnings have already been reported by the company, the trailing PE ratio is based on accurate data. Because this is a trailing indicator, despite being accurate, it can be only so helpful when used by investors to make predictions about the future performance of a given investment.
Forward PE Ratio
Since investors are often more interested in the future performance of an investment than its past performance, the earnings guidance issued by the company to estimate its future EPS can be helpful. By using this estimation in the denominator of the PE ratio formula, a rough forward-looking price-to-earnings ratio can be estimated. Here the information speaks to possible future earnings but is still based on an estimate, making it inherently less accurate.
Shiller PE Ratio
The Shiller PE, also known as the CAPE ratio (cyclically adjusted price-to-earnings ratio), uses the average inflation-adjusted past earnings from the last ten years as the denominator. This decade-long period of past earnings “smooths out” earnings numbers by minimizing the effect that the business cycle can have on a company’s profits. If a decade’s worth of historical earnings information is available, this method of determining earnings is generally considered more accurate, but keep in mind that this calculation does not have a forward-looking component.
Uses Of The PE Ratio
The most common use of a PE ratio is to assess the value of different companies in an industry and identify the overvalued and undervalued players. To put it another way, price-to-earnings ratio is a method of making an apples-to-apples comparison among companies in the same industry.
What does a high ratio indicate? price-to-earnings ratios don’t paint the whole picture when evaluating a stock. Stocks with remarkably high ratios may be overvalued or they may have high growth potential. As an example, Tesla has a high PE ratio because investors are optimistic about the success of the company and the growth prospects of the electric vehicle industry. By this metric alone, however, we can’t determine whether or not Tesla is overvalued.
A high PE ratio also indicates that the stock is expensive. The higher the ratio, the longer an investor has to wait to recoup their investment. On the other hand, a low ratio can help point to the fact that share price is more in line with the true value of the company in question, or even a growth prospect that is undervalued. Stable companies have PE ratios that are closer to the industry metrics, while growing companies tend to have relatively higher ratios.
Limitations Of The PE Ratio
Calculating the PE ratio of a company can be a good back-of-the-envelope way to screen stocks and refine your search for undervalued investments. Used alone, however, the price-to-earnings ratio doesn’t indicate anything about the fundamental value of a company based on its profitability, cash flows, or distinctive competencies.
Another way in which price-to-earnings ratio falls short is that the number can be easily manipulated. Although corporate earnings is a financial metric that all publicly owned companies are legally obligated to provide, earnings can be impacted by a number of market factors. This is why the Shiller ratio, the ratio that uses a decade’s worth of data, is much more accurate than the others.
In the case of using a forward PE ratio based on earnings guidance, considerable limitations exist. Management can set overly optimistic expectations to boost short-term ratios and stock prices, or their estimates can prove entirely wrong in the face of unforeseen market conditions.
Despite these limitations, the price-to-earnings ratio remains one of the most widely used valuation methods, as it can be used to quickly shortlist companies from a large pool of prospective investments. The success of any business depends on its earnings potential, and the PE ratio rewards companies based on their ability to generate earnings.