For years, investment professionals and analysts have considered the Price to Earnings (P/E) ratio as one of the most important ratios in fundamental security analysis.
A solid understanding of how this ratio works and what goes into it is essential if you are going to own individual companies in your investment portfolio. Even if you aren’t looking to own individual companies, you can still use P/E to evaluate sectors, industries, economies, etc.
By the end of this article, you will understand what P/E is, what goes into it, and some important considerations to keep in mind regarding the ratio.
Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. This article is not investment advice. Always consider your personal situation – and the help of a licensed financial professional – when making any investment decisions.
P/E Ratio Meaning
Very simply, the P/E ratio measures a stock’s market value per share, divided by its Earnings Per Share.
You can calculate market value per share by dividing a company’s market capitalization by its outstanding shares.
Earnings per share is measured by dividing a company’s earnings by its outstanding shares. Another way of describing P/E is how much an investor is willing to pay per dollar of EPS. For example, if a firm has a P/E of 5, that means investors are currently willing to pay $5 per $1 of Earnings per Share.
Peter Lynch described P/E as the number of years it will take to recoup your principal in the investment. According to his standards, if a company has a P/E of 10, it would take 10 years to receive 100% return on your investment. Keep in mind this is more of a mental shortcut versus an investing law.
P/E is often used to determine whether a company is currently overvalued or undervalued with respect to its earnings. Keep in mind, P/E ratio is not the only ratio that you should look at when evaluating a company.
Forward vs Trailing
If you are researching a company, you may notice reports that hint at Trailing and Forward Price to Earnings.
Trailing P/E refers to the ratio that is calculated when used trailing EPS. This figure usually refers to the earnings per share that a firm realized over the past 12 months. This is the Trailing 12 months, or TTM. Analysts like using this figure because it takes into account what a company has actually done in terms of earnings. However, it does not provide you with much guidance as to the potential future earnings picture of the company.
Forward P/E is the opposite of trailing P/E. Instead of looking at historical data, forward (or leading) Price to Earnings takes into account future earnings guidance that is provided by the company, usually after earnings announcements.
Investors tend to purchase equities because they believe the future prospects of a company’s earnings are positive. In theory, this should reflect an increase in the market value of the company’s stock. Whether or not you believe forward P/E is a good way of analyzing a company’s stock price is reliant on whether or not you trust a company’s guidance.
Many investment professionals tend to be cautious when trusting a company’s guidance because companies may try to understate earnings projections in order to “beat” them in the future, or they may overstate them in order to try to improve shareholder sentiment.
Whether you use trailing or forward P/E, it’s important to understand the limitations of both.
Growth vs Value
Growth and Value investing are among the most popular styles of investing. One of the first metrics that investors look for when classifying a stock is the P/E ratio.
Generally, value companies hold lower P/E ratios compared to growth companies. This is possibly due to the fact that the company is “undervalued” relative to its earnings or book value.
This is what makes value companies so attractive to value-oriented investors. The main risk with value companies is the “value trap”, meaning that the share price may never go anywhere, causing an investor to lose out on the opportunity cost of growth in other segments of the market.
Growth companies, on the other hand, tend to have higher P/E ratios than value companies and the overall market. This is due to the fact that the company’s share price is reflecting a lot of optimism about the company’s future prospects. A common risk among growth companies is that they may be “overvalued” relative to their current level of earnings. Worst-case scenario, an investor will buy into the hype of a company and will purchase its share price at its peak.
Comparing Apples to Apples
Making an investment decision based off of P/E ratio alone may be dangerous. It is typically best to measure the ratio against a certain benchmark, like the S&P 500’s P/E ratio. Even better, you may want to consider evaluating the P/E of a company relative to its industry or sector peers.
Different sectors have different standards for what is a “reasonable” P/E. For example, it makes very little sense to compare the P/E of Advanced Micro Devices to that of Procter & Gamble. A high P/E ratio alone may not mean that the company is overvalued if the
entire sector or industry that it belongs to boasts a high P/E as well.
This is why the phrase “know what you own” goes a long way in your investing.
When making investment decisions based off of P/E, it’s important to know that there are ways that the ratio can be “artificially” inflated, meaning that the relevance of the P/E ratio is over-inflated in some cases.
Share buybacks are one of the most common ways of manipulating the Earnings Per Share of a company. Remember, the number of outstanding shares is the denominator in the EPS equation. If you reduce the amount of shares in the marketplace, EPS is likely to go up, even if earnings remain flat.
This is why it’s important to take a deeper dive into the financials of the company to see what the earnings per share is actually due to. In a cheap liquidity environment, like the one we’re witnessing, it is very possible that equity bull markets can be fueled by crafty accounting and share buyback programs.
P/E Ratio of Zero
If you ever see a P/E Ratio of zero, it means that a company has not yet posted earnings or they are experiencing losses as a company.
A great example of this phenomena is Tesla’s stock. As of the writing of this publication, Tesla’s shares are valued at $800.03. They have a TTM (trailing 12 months) EPS of -4.92. This means that there has been a loss of $5 reported per share over the past 12 months. If you look up the P/E of Tesla on a site, like Yahoo Finance, you will see it report as N/A, or effectively 0.
It is usually not practical to report a negative P/E ratio. You also cannot divide by zero. In this case, you have to rely on other methods of analysis, like DCF to analyze whether a company’s shares are trading above or below their “fair market value”.
What Are Some Limitations Of The P/E Ratio?
As with all of the other tools available to analysts, the P/E ratio is not perfect, meaning that it’s not recommended you make an investment decision off of it alone.
If you are using the P/E ratio based on trailing EPS, keep in mind that the data is historical in nature. Past performance is not indicative of future results.
If you are using forward P/E, keep in mind that guidance estimates are just that; estimates. It is difficult to accurately predict earnings, as there are a lot of variables at play. Also, earnings guidance skew one way or another for a number of reasons.
If you’re looking for further context, you could look into the PEG, or Price to Earnings Growth ratio. This ratio factors in earnings growth of the company. Keep in mind, the PEG has limitations as well. If you are looking at historical growth data, that data is still heavily weighted on past performance. If you are using future earnings growth projections, you are still having to make an educated guess on the future of the company.
In short, no fundamental analysis ratio is perfect. Ideally, you want to make use out of all of them in order to create a well-rounded picture of where the company currently stands and what its future prospects look like.
A Final Word on the Meaning of the P/E Ratio
As discussed, understanding P/E can help you begin to understand a company’s valuation relative to its peers and its own earnings.
If you belong to the fundamental analysis school of thought, this is one of the most important ratios that you will use in identifying suitable companies to add to your investment portfolio.
While it is not perfect, P/E and its variations are used by investment professionals and analysts globally in their analyses and research.
You can find information on a company’s P/E ratio via a quick Google search. It is usually one of the first metrics that come up after searching a ticker symbol on the search engine. You can also leverage sites like Yahoo Finance or Morningstar to find historical P/E data, analysts’ opinions and more.
Knowing the analysis tools that are available at your disposal goes a long way. Understanding the meaning and application of the P/E Ratio is no exception.
Have questions on the Price to Earnings ratio? Let us know!