The price to earnings ratio (P/E ratio) represents a company’s current share price compared to its earnings per share.
Commonly referred to as the earnings multiple, the P/E is commonly used by investors to compare and analyze stocks, as well as determine if a company is under or overvalued.
There are many different versions of the price to earnings ratio which are often used to understand past, present, and future valuations. This simple formula can give you a rough idea of the value of a stock and help you determine which ones will be best for your investment money.
How the Price to Earnings Ratio is Calculated
The most common price to earnings ratio that is tracked is known as the trailing P/E. This calculation uses the earnings per share (EPS) from the past four quarters and the current share price. The equation to run the calculation is highlighted below.
P/E = Share Price / Earnings Per Share
A stock that is currently trading at $20 per share that reported earnings over the past 12 months of $1.00 per share would have a P/E = 20. This calculation is represented below –
Trailing P/E = $20 / $1.00 or 20
If the projected earnings for the company were expected to reach $1.25 in the next 12 months, an investor could calculate the future P/E using the same equation. In this scenario, the future P/E would equal 16. This is important information for an investor as the current share price may seem like a good bargain compared to the future.
Future P/E = $20 / $1.25 or 16
There are also some price to earnings calculations that use a combination of past and future earnings projections. One version takes the earnings results from the past two quarters and adds them to projections from the next two future quarters.
Since there are plenty of different ways to calculate and represent a P/E, it is important for the investor to understand the differences.
How to Determine a Stock’s Value
Some stocks have high P/E ratios while others have lower valuations. This does not mean that the stock with the lower P/E is more valuable at its current share price compared to the stock with the higher earnings multiplier.
Each type of stock is valued differently in the market and investors need to understand this. Growth stocks that are expected to see above average earnings increases tend to have much higher P/E ratios than those of establish companies that are not growing as fast.
The important thing to remember is that even though every stock has a P/E ratio, there are different valuations that are acceptable within the market depending on many other factors.
Why the P/E Matters
Now that you hopefully understand how it’s calculated, you might be wondering what you’re supposed to do with it. Well, that’s where it gets even more complicated.
One important factor to consider when looking at a P/E ration is the industry. Each industry has different ranges for what they consider “normal.” For example, a medical equipment company is going to have a drastically different acceptable range for P/E compared to restaurants.
The P/E formula is an excellent way to compare companies within the same industry. If you’re looking at two companies in the same industry, you can use this formula to determine which one might fit your portfolio.
Let’s say there are two companies, both of them are selling stock at $50. Now, Company X reported earnings of $20 a share, while Company Y reported earnings of $10 a share. Company X is going to have a much lower ratio compared to Company Y. For most people, they are going to purchase the shares from Company X because of the higher earning potential.
Beware of P/E Ratio
While the P/E ratio is a quick and easy way to compare companies and determine relative value, there are some pitfalls of using the formula. One of the most notable is because it doesn’t account for growth rate.
Just because a company has a good P/E ratio doesn’t mean you should automatically go out and buy those stocks. The ratio doesn’t account for things like longevity, management, or the financial stability of the company.
This is why a lot of investors choose to use the PEG ratio or the dividend adjusted PEG ratio because it factors in some other components of the stocks. With these formulas, it looks at the P/E ratio and then adjusts it for the rate of growth and the yield of the stock.
The price to earnings ratio, also called the earnings multiplier, is a representation of a company’s current share price to its reported earnings per share.
The P/E of a company can be calculated for past and future earnings as well as a combination. Investors must understand just exactly what type of P/E numbers they are looking at before making any type of investment decision or comparing it against other stocks.
If you’re new to investing, or you don’t fully understand the ratios or what they mean. I would suggest meeting with a financial advisor.
They can walk you through the calculations and help you decide which stocks are going to be best for your portfolio and your goals.
Maybe you’ve done the research and looked at the formula, but you’re still not comfortable managing your stocks, this is where a financial advisor can be a life-saver.
Investing is one of the most important tools for reaching your retirement. It can be a mix confusing and stressful decisions, but it doesn’t have to be. There are plenty of tools and resources to ensure you’re making the wisest choice for your money.
Do you use the P/E ratio when determining the value of a stock? Do you prefer using the future or trailing calculation?