The price to earnings ratio (P/E Ratio), also known as the Price Multiple or Earnings Multiple, is a ratio used for measuring the value of a company. The P/E ratio measures the current price of a share relative to the EPS, or Earnings per Share.
A share with a high P/E indicates that investors anticipate earnings growth down the line, but can also signal a stock that is over-valued. Likewise, a low P/E can indicate that a stock’s price is low compared to earnings and potentially undervalued.
Price-to-Earnings Ratio Formula
To determine the P/E ratio, one must divide the price per share by the earnings per share. Current price per share values found through most financial resource sites, while earnings per share are often reported on a quarterly or yearly basis via the same channels.
Earnings per Share
There are two main varieties of EPS that are used in the P/E Ratio. The first, known commonly as “P/E (TTM)” (TTM stands for Trailing Twelve Months), signals a company’s performance over the last 12 months. This can generally be found on most finance-tracking websites and is more commonly used. The other form of EPS, which serves as a company’s best guess of future earnings, can be found in a company’s earnings release.
Price-To-Earnings Ratio Example
In this example, assume a fictional bank has shares valued at $23.10, while the earnings per share sat at $3.14. Using the P/E ratio, one can determine that the company was trading at about 7 times their earnings.
It is important to compare the P/E of company to their competitors to glean if their stock is overvalued or undervalued in the current market.
Price-To-Earnings Ratio Analysis
The P/E is often referred to as the price multiple because it shows how much an investor may be willing to pay for a dollar of a company’s earnings. If the fictional bank above happened to be currently trading at a P/E multiple of 15x, that investor would effectively be willing to pay $15 for $1 of current bank earnings.
Multiple versions of the P/E ratio are often used. Examples of these include:
- Trailing or Current P/E: Analysts use earnings for the most recent 12 month period and drop the oldest quarter in favor of the new quarter as time goes on.
- Projected or Forward P/E: Instead of current earnings per share, the projected or estimated EPS for the next 12 months is used.
- Combined or Mixed P/E: Some combination of the 2 most recent quarters and the 2 upcoming are used in place of current EPS.
No matter which version of the P/E is used, it is important to stay consistent when comparing different companies and ensuring that the periods you’re comparing line up properly.
Different industries or sectors also tend to have different P/E ranges that are considered normal. While food wholesalers may trade for, say, a P/E ratio of 17, aerospace/defence contractors often trade more in the range of 35.
While it’s important to ensure that companies in the same industry are trading roughly where they should, it’s completely normal for different industries to have wildly different P/E ranges.
One can use these average industry P/E ratios to determine if an industry is greatly overpriced. If industry-wide P/E’s suddenly climb far-higher than the historical average, it can be a big red flag for investors. These situations don’t arise very commonly, so it’s even easier to spot when happening and act accordingly.
Price-to-Earnings Ratio Conclusion
- The P/E ratio is used to measure the value of a company.
- P/E is a good indicator of whether or not a stock is undervalued or overvalued.
- P/E can be determined using current or projected earnings.
- Likewise, EPS comes in two different forms for past and projected future earnings.
- P/E is a very quick and easy calculation that is very useful in making quick comparisons between companies.
- Different industries often have different P/E ranges.
Price-to-Earnings Ratio Calculator
1. What is the price to earnings (P/E) ratio?
The price to earnings ratio (P/E Ratio), also known as the Price Multiple or Earnings Multiple, is a ratio used for measuring the value of a company. The P/E ratio is calculated by dividing the current share price by the earnings per share (EPS).
2. What is a good price to earnings (P/E) ratio?
Analysts often use a P/E ratio of 15 as a benchmark when determining if a stock is overvalued or undervalued.
3. Is it better to have a higher or lower price to earnings (P/E) ratio?
A higher P/E ratio means that investors are expecting higher future earnings and thus are willing to pay more for a dollar of current earnings. This can be seen as a good sign if the company is expected to continue growing at a fast pace. On the other hand, a lower P/E ratio usually signals that the company is undervalued and may be a good investment opportunity. This can be due to several factors such as poor past performance, industry cyclicality, or simply being early in the company's life cycle.
4. What is the purpose of understanding the price to earnings (P/E) ratio?
The price to earnings ratio can be used to measure the value of a company. It can also be used to determine if a stock is overvalued or undervalued. Additionally, it can help investors quickly compare different companies.
5. How is the price to earnings (P/E) ratio calculated?
The price to earnings ratio is calculated by dividing the current share price by the earnings per share (EPS).
The formula is:
P/E Ratio = Current Share Price / EPS