Price to Earnings Ratio: Formula and its Use in Valuing Stocks

What is Price to Earnings Ratio?

Price to Earnings Ratio, or 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.

See: value stock definition

P/E Ratio Formula

P/E Ratio = ( Price / Earnings per share )

Where,
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.

Related: PEG ratio formula

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.

Also see: P/B Ratio

Negative P/E Ratios and Finding Turnaround Opportunities

If a company has incurred losses in the last year, the P/E 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 [what is profit margin]. 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.

More critical stock ratios you should know

Fine Tuning the Price to Earnings Ratio

The historical average for the P/E ratio for the market is about 15. Generally, all other things being equal, a P/E ratio of 15 for any given stock can indicate a fair price.

However, all things are not always equal.

The observed price/earnings ratios may hide many things behind the scenes and may not represent a good indicator of the value. Many accounting adjustments and treatments can artificially inflate or deflate the earnings in a given time period, in which case the price to earnings ratio can be atypically low or high. Many stocks and industries or even entire markets can go through cyclical ups or downs in earnings, which can cause unnaturally high or low P/Es. For example, the economy tends to move in 10 year cycles. When the economy is doing well, the earnings rise quickly and the price to earnings ratios can get excessive. Reverse happens when the economy goes in a downturn. The 10 year cyclically adjusted PE, CAPE, or also called Shiller P/E, is an attempt to adjust for the cyclical effects in the economy.

Read more about pe ratio interpretation

Another point to note is that in cases where a company has significant cash on the balance sheet, a P/E ratio based valuation may not fairly value the company. In such cases, ex-cash price to earnings ratio can be used instead.

One of the criticisms of the price to earnings ratio as a valuation metric is that it essentially treats businesses in different industries in the same way. Is a dollar earned in a service based company the same as a dollar earned in a manufacturing company? Do they create the same amount of shareholder value, or should shareholders value these two dollars differently?

This is often an area filled with ambiguity and speculation. Once enough arguments were made to support the contention that IT companies should be valued differently. For example, R&D programs have great value, and higher Price to Earnings ratios could be tolerated to account for this extra value. This led to the internet bubble that eventually burst.

My advice is to use the Price to Earnings ratio as just one indicator. Do not base your entire investment decision on the P/E ratio.

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 Price to Earning Ratio can be a solid indicator of value, if seen in isolation it has a potential to mislead or misinform.