P/E Ratio Primer: Why the Price to Earnings Ratio Is Crucial

Daniel Penzing
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Defining the P/E Ratio

It’s no surprise our website covers businesses. And if you have even a passing interest in the stock market, you’re probably well aware that a valuable way of investing is to seek out the kinds of high quality businesses that are likely to continue to deliver stellar performance.

But how do you go about valuing a company? What factors should you consider? Generally, the most common thing markets look at is a business’s price to earnings ratio, or P/E ratio. The price to earnings ratio uses the stock price and earnings per share to derive a value.

The price to earnings ratio has been used by investors for decades as a simple way to evaluate the value of stocks in the market. In case you aren’t familiar with our website yet, we’ll just point out that we are the P/E Ratio experts. So we’ll be using this knowledge base to answer the most common questions about the P/E Ratio. Without any more preamble, let’s get going with the P/E ratio primer.

What is the meaning of the P/E Ratio?

Turning It Upside-Down

Most people ignore P/E. They assume that a company with a higher P/E must be overvalued, or that a company with a low P/E must be undervalued. This is a very dangerous way to think about the ratio because it misses an important point: the P/E ratio depends not only on the current valuation of the company, but the expected future earnings of the company as well.

Let me show you what I mean using the following example: what happens if a company has two possible courses for its future? The first one is a very gradual growth, a slow, steady increase in earnings over the next five years. The second course is an explosive growth; the company puts out some amazing new product or service. The resulting growth leads to huge earnings in three years, and a much smaller increase in earnings over the next two years.

In this example, the company has very different P/E ratios based on which path it follows.

The first company has a P/E of 50 based on 20% future growth. But the second company has a P/E of 75 based on growth of 250 percent. That sounds stupid until you realize that many of the tech companies in the late 1990s had P/Es very similar to the above example.

Interpreting the P/E

When evaluating a stock, knowing the price to earnings (P/E) ratio is crucial.

In general, the P/E ratio tells you what the market is willing to pay for a company’s earnings. Or, more simply, how many times a company’s share price is trading for their earnings per share. This can be a good indicator of what the market thinks will happen in the future.

For example, if you bought a stock trading at a P/E of 10 and the company decides to cut expenses and increase earnings, it would be expected that the price of the stock would go up more than if the P/E had been 15.

Generally, stocks will trade at an average P/E of around 20. This might sound a bit high, but when compared to other financial assets, stocks are actually low. Bonds, for example, have a P/E of 4 or 5. So on average, stocks are priced lower, even though they have the potential to increase by more.

Of course, no one way to measure stocks is perfect. The key to using the P/E ratio is to compare it to the sector the stock is in, other stocks, and other measurements like cash flows, research and development, etc.

The Details Matter

Which EPS, Actual or Forecasted?

What if there are two different EPS figures, one actual and the other is a forecasted estimate?

Companies are required to report their earnings four times a year: on a fiscal quarter basis, on a calendar quarterly basis, or in accordance with the International Accounting Standard. The one that is most significant to investors and is typically reported is the quarterly earnings. But companies must also report the earnings that are based on a calendar year and, therefore, referred to as the full-year earnings. When comparing a company’s actual earnings (based on a calendar or fiscal year) with an estimate for the current year, the most important thing to keep in mind is which earnings to use.

Are High PEs Irrational?

As a general rule, the lower the PE, the greater the uncertainty. You must remember one key fact about this ratio: its value cannot be calculated for startups (a company that has yet to turn a profit) with little or no earnings.

However, if you do want to still evaluate value, companies that are startups can be evaluated on a P/S ratio. This essentially tells you how much the market values the company as an asset (whether you can value the whole business or just part of the business).

There are a few types of P/E ratios. You can verify this by checking the sources below.

Common types of P/E ratios include:

  • Price-to-earnings ratio
  • Earnings-per-share ratio
  • Earnings multiple
  • Price/earnings to growth multiple
  • Price-to-asset ratio

To calculate PE, you can use the following formula:

If we dive a little deeper into the specific uses of the P/E ratios, we can learn a lot from the PE ratios.

Many investors use the P/E ratio as a quick way to assess the value of a company.

In a nutshell, it’s value is….

Comparisons Are Useful

P/E And P/E Ratio

When you take the time to look at a stock’s P/E ratio, you will definitely understand why many investors tend to value stocks with this ratio more than stocks with a higher ratio. In most cases, you will find that stocks with a higher P/E ratio are not always better stocks, in terms of the potential to generate decent returns, and thus fail to justify the high price. If you’re conscious of the different ratios and use various ratios to analyze a stock before you invest in it, you will be better equipped to spot good stocks from bad stocks.

Since a high P/E ratio is looked down upon in the industry, many investors might wonder why it’s so important or useful to look at the P/E ratio. Is it because they are making a stock pick? If the goal is to pick good stocks, shouldn’t they pick the ones with the highest P/E ratios?

Understanding the P/E ratio is a great starting point for looking at a stock from the financial perspective. As an investor, you need to focus on the following things to be able to develop a feel for the company and decide whether you want to invest in it:

A. Revenue Growth

B. EPS Growth

C. Business Model

D. Management Teams