What is P/E Ratio?
P/E Ratio is one of the most common valuation metric used to identify stocks attractively priced for investment. As the name implies, the Price/Earnings Ratio is simply the price of the stock divided by the earnings per share as reported by the company. Most commonly, the last 12 months of eps is used (also called ttm for trailing twelve months). Other variants include Forward P/E Ratio, which uses the earnings estimates for the next 1 year as the denominator.
P/E Ratio Formula
P/E Ratio = ( Price / Earnings per share )
Price = price of the stock in the market today, usually as of last close
Earnings per share = Total net income per common stock in the last 1 year (ttm eps)
Normally P/E Ratio is referred to as a number, such as 10. Alternatively, it can also be referred to as a multiple, such as 10x earnings.
Another equivalent way of calculating the P/E ratio straight from the corporate financial statements is as follows:
P/E Ratio = ( Market Value / Net Income attributable to common stock )
Note that these formulas are equivalent as Price is the per share value of the Market Value (or Market Capitalization) of the company and Earnings per share is a per share value of the Net Income.
Price to Earnings Ratio Analysis
P/E Ratio essentially refers to the willingness of an investor to pay up for each dollar of earnings. A normal rule of thumb for a conservative investor is to pay less than 15 times earnings to purchase a stock. This implies that the shares thus purchased will take about 15 years to earn back the price paid for them from the normal course of business, if the business continues at the same rate as today.
Looking at this ratio in this light, it makes sense for a conservative investor to require a faster payback time. This is what a value investor does when he requires a low P/E ratio in his investments. On the other hand, a growth investor may look for companies that will accelerate the payback by rapidly increasing earnings every year, and he may be willing to pay a higher multiple to acquire such shares.
Negative P/E Ratios and Finding Turnaround Opportunities
If a company has incurred losses in the last year, the P/E Ratio calculation will use a negative eps in the denominator, and therefore result in a negative P/E ratio. Screening for stocks with a P/E Ratio above 0 effectively eliminates unprofitable companies. At the same time, it also eliminates temporarily unprofitable companies that may turn around quickly and generate significant profits for investors. One potential way to find these companies is to run a screen for negative P/E Ratio using past 12 month earnings and a positive Forward P/E Ratio that reflects profitable earnings estimates going forward. Keep in mind that future estimates are normally unreliable, so one needs to come to their own conclusions.
Valuation Ratios are Better Used Together
Each financial ratio only gives one side of the story. To form a complete picture of a potential investment (or sale), one needs to consider other metrics as well. While P/E Ratio can be a solid indicator of value, if seen in isolation it has a potential to mislead or misinform.