Definition of 'Price-Earnings Ratio - P/E Ratio'

Market R · 1 Definition of 'Price-Earnings Ratio - P/E Ratio' Wed Sep 03, 2014 6:31 pm

Market R

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A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:

Market Value per Share / Earnings per Share (EPS)

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

Also sometimes known as "price multiple" or "earnings multiple."

Investopedia explains 'Price-Earnings Ratio - P/E Ratio'

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

Things to Remember

•Generally a high P/E ratio means that investors are anticipating higher growth in the future.
•The average market P/E ratio is 20-25 times earnings.
•The P/E ratio can use estimated earnings to get the forward looking P/E ratio.
•Companies that are losing money do not have a P/E ratio.

Market R · 2 Re: Definition of 'Price-Earnings Ratio - P/E Ratio' Wed Sep 03, 2014 6:36 pm

Market R

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How can the price-to-earnings (P/E) ratio mislead investors?

The price-to-earnings (P/E) ratio is calculated by dividing a company’s stock price per share by its earnings per share (EPS), giving investors an idea of whether a stock is under- or overvalued. While the P/E ratio is a useful stock valuation measure, it can be misleading to investors. One reason is that a P/E ratio based on past data (as is the case with trailing P/E), does not guarantee earnings will remain the same. Likewise, if the P/E ratio is based on projected earnings (for example, with a forward P/E), there is no guarantee that estimates will be accurate. And, accounting techniques can control (or manipulate) financial reports. EPS, therefore, can be skewed, depending on how the books are done. This can make it difficult for investors to accurately value a single company or compare various companies since it may be impossible to know if they are comparing similar figures.

Another problem is that there is more than one way to calculate EPS. In the P/E ratio calculation, the stock price per share is set by the market. The EPS value, however, varies depending on the earnings data used; for example, data from the past twelve months or estimates for the coming year. Comparing one company’s P/E ratio based on trailing earnings to another’s forward earnings creates an apples-to-oranges comparison that can be misleading to investors. For these reasons, it is recommended that investors use more than the P/E ratio when evaluating a company or comparing various companies.

A quick look at P/E ratios for Apple Inc (AAPL) and Amazon.com Inc (AMZN) illustrates the dangers in using only the P/E ratio to evaluate a company. Apple was traded at $92.18 with a P/E ratio (TTM) of 15.34. On the same day, Amazon’s stock price was $334.38 with a P/E ratio of 511.06. One of the reasons Amazon’s P/E is so high is that it always reinvests its earnings. If you were to compare these two stocks based on P/E alone, it would be impossible to make a reasonable evaluation. A low P/E ratio doesn’t automatically mean a stock is undervalued, just like a high P/E ratio doesn’t necessarily mean it is overvalued.

NilangaG · 3 Re: Definition of 'Price-Earnings Ratio - P/E Ratio' Wed Sep 03, 2014 8:54 pm

NilangaG

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My understanding is that if a company is showing consistent profitability, PE value gives us a very good indication whether the price is undervalued or not.