Price to Earnings Ratio - (P/E Ratio)

What is Price to Earnings Ratio?

Price-to-earnings ratio is the ratio of a company’s share price relative to its earnings per share, which is generally for the last twelve months earnings or annual. Also known as earnings multiple, it is widely used by market participants while referring to valuations.

It also reflects the current investor demand for any particular stock. A high P/E ratio would mean that investors are expecting high growth from the company over the future, therefore buying pressure pushes up the price of stock or investors are ready to pay high price for the stock.

A low P/E ratio would mean investor demand is lacklustre, which can be due to various reasons, including business outlook, anticipated deterioration in earnings of the firm. Alternatively, the P/E ratio is also used to determine whether the stock is undervalued or overvalued.

During an expansionary phase, a company’s share could trade at high P/E multiple because investments in expansion can lead to suppressed earnings, while investors continue to expect high growth as a result of the expansion.

If the current price of the stock is $100, and earnings per share are $20, the P/E ratio would be 5x.

There is one more interesting way of looking at a P/E ratio, i.e. the ratio also indicates the no of years it would take for the investor to earn back the invested amount in the form of earnings.

For example, if the P/E ratio is 5, it means it would take 5 years to get back the invested amount in the form of earnings, assuming no change in earnings. The reader must not confuse earnings with the stock price appreciation.

Watch this video: What is PE Ratio? | Price to Earnings Ratio Explained

What is forward P/E ratio?

Forward P/E ratio is also similar to the P/E ratio, but it measures price relative to predicted earnings per share of a company. When the forward P/E ratio of a share is higher than the P/E ratio, it would mean that investors are willing to pay more for the future earnings, as they might be anticipating an improvement going forward. However, one should look at these numbers over couple of quarters, as at times, due to quick market reactions these numbers could be distorted.

Predicted earnings are provided by analysts covering the stock. Market data providers collect the financial forecast of analysts for companies and compile those estimates for consensus estimates of a company’s expected future performance. Fund managers also use this ratio in their analysis.

What is TTM P/E ratio?

Trailing twelve months P/E ratio is perhaps the most used P/E ratio. It is similar to normal P/E ratio, but the earnings per share are taken for the last twelve months, which can be six months from previous financial year and six month from the current financial year.

EPS in TTM price-to-earnings is the reported number by the company. It is why most investors prefer relying on TTM P/E as it shows the actual performance of the firm rather than predicted. When TTM P/E ratio is higher than the forward P/E ratio, it indicates analysts are less bullish as compared to before.  

Absolute P/E ratio Vs Relative P/E ratio

Absolute P/E ratio is the ratio where the denominator is either predicted earnings or past earnings of the company. Relative P/E ratio compares the absolute P/E ratio to past P/E ratio for a time period. Moreover, a relative P/E ratio compares the current P/E ratio to the historical P/E for a company’s share.

Do read: Understanding Price-Earnings Ratio

Value investing, Growth investing and P/E ratio

Value investing and growth investing requires an investor to evaluate the intrinsic value of a stock and compare it to the current market price. Price-to-earnings is an important consideration in both the styles of investing. A company trading at a high P/E multiple compared to similar companies would indicate that it is overvalued.

But value investors and growth investors are inclined to evaluate why the investors are ready to pay high multiple. There could be many reasons about the high P/E multiple such as better debt-to-equity ratio that peers, expected high growth in earnings.

Dividend also plays an important role for value investors, and companies that pay dividends are preferred by value investors. Value investors also compare liquidity levels of business and compare it to similar companies.

Moreover, a high or low price-to-earnings ratio triggers value investor to uncover the reasons behind such a scenario. When markets underestimate the potential of the business, value investors believe that the stock is undervalued and worth buying.

While growth investors tend to look at reasons as to why the stock should command high P/E ratio or rather increase it P/E ratio over time due to good business dynamics, aided by microeconomic or macroeconomic indicators.

What are the limitations of P/E ratio?

Price-to-earnings ratio is not the only metric to evaluate the fundamentals of a business, and investors use the P/E ratio along with other metrics to arrive at a decision. Companies with relatively high debt levels can have lower P/E ratio as they would pay comparatively higher interest costs, suppressing earnings, and also the inherent risk of default.

Comparison of P/E ratios is undertaken with similar companies. One should not compare the P/E ratio of telecommunications business with a retail business. P/E ratio is useful to shortlist companies in an operating sector/industry or sub-industry. P/E ratio is not useful in case of cyclical businesses. As, such businesses quote high P/E ratio during times of low business growth and low P/E ratio during times of high growth, as their EPS is bloated at such times as compared to historical figures.

When a stock is trading in low P/E multiples, it does not necessarily mean that the stock is undervalued. A low P/E ratio can also mean that the market participants are expecting a lacklustre performance from the business.