What does the price to earnings ratio mean and what does it involve?

What a price to earnings ratio can tell you and how it’s calculated.

The Price to Earnings Ratio (or P/E ratio) is a financial ratio used for equity valuations consisting of the price paid for a company’s shares divided by its earnings per share. For example, a company with a $5 share price and $0.50 per share in net earnings would have a P/E of 10.

Earnings or profits per share can be based on the past year’s reported earnings (trailing P/E) or on projections of earnings expected in the next financial year (forward P/E). Variations may also exist, with the use of averages or longer periods of time.

The earnings figure may also be adjusted to exclude extraordinary events or one-off gains or losses. As reported earnings are an accounting measure, they are subject to discretion by companies and auditors, meaning that sometimes the P/E ratio can be misleading – for example if the company has made a large write-down in its assets resulting in a reported loss then the P/E will be negative and therefore not a particularly good guide as to whether the company’s shares represent good value. Equity analysts often adjust and standardise earnings so that more useful comparisons can be made.

If the company’s P/E remains constant over time and the earnings are growing at say 10% per annum then we could expect that the share price will also rise by 10% per annum – an attractive return when dividends of 5% per annum are added into the total return calculation. But, if stock prices rise and earnings remain the same or go down, then P/E rises implying that the company’s shares are more expensive (relative to earnings). This would be a reason why P/Es need to be assessed compared to historical P/Es and compared with comparable companies.

Typically, a high P/E ratio suggest that investors are expecting higher earnings growth from a company compared to another with a lower P/E ratio. Stocks from the same market sector with higher forecast earnings growth will usually have a higher P/E and those expected to have lower earnings growth will, in most cases, have a lower P/E.

Making an investment decision should not be solely based on a P/E. Companies are rarely equal, so a comparison between industries, companies and time periods needs to be done with great caution. In addition to P/E other metrics to look at include dividend yield, discounted cash flow valuation, earnings per share growth rate and enterprise value ratio (which is like a P/E but looks at the total value of the company, including debt, relative to its gross earnings before interest, tax, depreciation and amortisation).

The P/E ratio is the inverse of the company’s earnings yield so a P/E of 10 times means that the company has an earnings yield of 10% per annum, so 10% of the share price is generated in earnings which can either be paid in dividends or reinvested by the company.

A stock market’s P/E is calculated as a weighted average of its constituents stock prices divided by the constituents weighted average of earnings. The average P/E of a market is influenced by expectations of growth and stability of earnings, expected inflation, tax rates, gearing and yields on competing investments. For example, when bonds yield high returns, investors may pay less for a given level of earnings per share and resulting in low P/Es.

 

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