The P/E price/earnings ratio is the most used multiple to evaluate the value of a stock. How is it calculated? How to use it? A complete guide and differences with EPS and earnings yield.
The P/E ratio, or price-to-earnings ratio, is an investor’s guide to the maze of stock valuations. It defines how much you are willing to pay for a stock based on its earnings. In essence, it measures the relationship between the current price of a share and the profit it generates.
This tool is the secret weapon of investors and analysts, as it offers a clear indication of the convenience of investing in a stock. But be careful, the P/E can be limited in certain investment contexts.
In this guide, we will explore in detail how P/E is calculated and how investors can take full advantage of this metric to make investment decisions.
What is P/E ratio?
The Price/Earnings Ratio, also known as the Price Earnings Ratio (P/E), is a key to the financial heart of a company. This indicator measures the relationship between a stock’s price and its earnings per share (EPS). In simpler words, it is how much the market is willing to pay for every single profit that a stock produces.
What does P/E mean?
The P/E is like the market’s thermometer of expectations for a company and indicates how many times the price of the stock examined incorporates the company’s profit.
The P/E is one of the indicators used to evaluate companies as possible investment targets.
If the P/E is high, it could mean that investors are optimistic about the company’s prospects and are willing to pay more for the denominator’s level of earnings. In other words, the P/E is also a measure of the market’s confidence in the company’s ability to increase its profits.
However, stocks with a high P/E can be more volatile and sensitive to changes in growth.
While a stock with a low P/E could be an investment opportunity, it could also suggest that the market has no confidence in the company’s prospects or that there are problems in the business.
Furthermore, P/E also has predictive power. If a company’s profits remain stable and not growing, the P/E ratio can give us an estimate of how many years it will take to recoup the initial investment for each share purchased. It is like an indicator of “repayability” in the long term. For example, if a company has a price-earnings ratio of 10, it means that the investor will have to wait 10 years to recover his entire investment at constant earnings.
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P/E, price/earnings ratio: calculation
How is P/E calculated? The price/earnings ratio is calculated by placing the price of a single company share as the numerator and EPS (earnings per share) as the denominator, i.e. the earnings per share.
The first step is to calculate EPS, with this simple formula:
| EPS = corporate net profit/number of shares issued |
Once we have calculated our EPS we can move on to the price/earnings ratio:
| P/E ratio = price of each share/EPS |
For example, let’s calculate the price/earnings ratio of a company
According to the formulas just seen,
| EPS = 5,000/10,000 = 0.5 dollars |
| P/E ratio = 5 dollars/0.5 dollars = 10 |
P/E can also be calculated in other ways.
It is also possible to calculate the P/E by dividing the company’s capitalization by its profits for the period, following the formula:
| P/E ratio = Capitalisation/Earnings |
Now that we know how to perform these calculations, it will be easier to decipher the P/E ratio and use it as a valuable compass to orient yourself among investment opportunities, understanding how much the market is willing to pay for a company’s earnings.
Why use the P/E ratio?
using the price-to-earnings ratio, or P/E, is critical for investors looking to maximize return on investment (ROI) by buying shares of financially strong companies.
Within market multiples, P/E is among the most used in the stock selection process, offering a clear perspective on how fair a stock price is.
The strength of the P/E ratio lies in its ability to standardize stocks with different prices and earnings, making it easier to compare companies in the same industry, regardless of share price fluctuations. Its speed and ease of use make it an intuitive tool for determining which company offers the best deal. For example, if we compare stock A at 30 dollars and stock B at 20 dollars, the P/E can reveal that, despite A’s higher price, we would pay less for every 1 dollar of current earnings than B.
However, the P/E should be interpreted wisely, is only one of the tools available for financial analysis. A comprehensive view requires considering several measures to evaluate future earnings growth. In summary, the P/E is a precious ally in the search for intelligent investments, but it should not be the only criterion for choosing investments.
P/E, price/earnings ratio: how many types are there?
Depending on the type of profits taken into consideration in the calculation of the ratio we can identify two "different" types of P/E:
- Trailing P/E: if in the denominator we consider the profits actually achieved and therefore expressed in the latest company financial statements.
- Forward P/E: as can be seen from the terminology used, in this case, the ratio takes into consideration not the profits achieved, but those estimated for the following year of operation.
P/E, price/earnings ratio: how is it used?
The P/E, as well as for a specific stock, is even more useful when compared to other parameters and from this point of view, we distinguish 3 of them.
Sector P/E: in this case, we compare the price/earnings ratio of a stock to that of other companies of the same size and in the same sector; the comparison is also made with the average P/E of the same sector taken into consideration and in this way, we can understand whether that stock is overvalued or undervalued.
Relative P/E: in this case we try to understand what investors’ perception is by comparing the stock’s P/E with its price/earnings ratio in a given period of time.
PEG Ratio: compares P/E to earnings growth (future or past). A stock with a P/E of 10 and growth of 10% has a PEG of 1, while a stock with a P/E of 10 and growth of 20% has a PEG of 0.5. From this perspective, the second company is undervalued compared to the first.
P/E ratio, price/earnings ratio: differences with earning yields (U/P)
The earning yields, in Italian U/P ratio, has a mirror definition to that of the price/earnings ratio, i.e. P/E. In other words, it is its reciprocal being equal to:
| P/U = earnings per share (EPS)/price of each share = 1/(P/E) expressed in % |
Let’s once again take a practical example to understand the definition, use, and method of calculation of these indicators.
The title X has the following characteristics:
- Price: 10 dollars;
- EPS: 0.50 dollars
- P/E: 20
- U/P: 5%
The title Y instead has the following characteristics:
- Price: 20
- EPS: 2 dollars
- P/E: 10
- U/P: 10%
In light of these data, and assuming that the two companies are similar and operate in the same sector, which of the two has a greater value? The most obvious answer is Y, given that from a valuation point of view it has a P /E lower, while it has a higher U/P, exactly 10% which means that for every dollar invested in the shares an EPS of 10 cents will be generated. In the case of company X, however, for every dollar invested, we would have an EPS of 5 cents.
Compared to the P/E, the U/P ratio, i.e. the earnings yield, allows us to evaluate the convenience between a share and a high-yield bond.
P/E ratio, price/earnings ratio: differences with EPS
As we have already seen in the section dedicated to the calculation of the P/E, the price/earnings ratio also differs from the EPS, even if the two measures are closely related (earnings per share being fundamental to P/E calculation).
EPS, or earnings per share, is the basic measure for understanding a company’s profitability. Earnings per share are calculated by dividing the company’s net profit by the number of ordinary shares issued by the company on the market. Just like the price/earnings ratio, EPS can also be of two types:
- Basic: is calculated by dividing the net profit available to ordinary shareholders by the weighted average of ordinary shares issued during the year;
- Diluted: ordinary shares represent an estimate based on the exercise effect and possible conversion of the securities.
Here, in short, is what the P/E is, what is its definition, its use, its calculation methods and what are the differences in the price/earnings ratio with EPS and earning yields.
P/E Limits
The P/E ratio, while a valuable guide in financial analysis, has limitations that require a cautious approach from investors.
Its value may not reflect current reality due to the static nature of the data used, considering that the share price is constantly fluctuating. Analysts try to mitigate this problem by adopting the “Trailing Price Earnings Ratio”, which incorporates the earnings from the most recent four quarters.
Secondly, the P/E does not consider the debt level of companies, making comparisons between companies with different financial leverage problematic. To overcome this challenge, analysts use “Enterprise Value/Net income” (EV/NI), which incorporates market capitalization and financial debt.
Furthermore, the P/E does not take into account extraordinary profits which could distort the company’s forward-looking valuation. To mitigate this risk, some prefer to use Ebit (Operating earnings before interest and taxes) as the denominator, giving a more accurate view of operating income. The most indicative metric, therefore, could be the trailing Enterprise Value/Ebit, which allows a more fair and comparable valuation between companies with different debt levels, minimizing the impacts of non-recurring profits.
Original article published on Money.it Italy 2023-12-24 15:02:02. Original title: P/E, rapporto prezzo/utili: calcolo, definizione e utilizzo
