P/E Ratio Explained

By: Rupesh Oli

What is the P/E Ratio?

P/E (Price-to-earnings) Ratio is one of the financial indicators to measure how much an investor pays to grab per dollar [or in any other currencies] of a company’s annual earnings. Simply, it reflects the willingness of investors to pay for a particular stock in order to earn a dollar from it. Hence, the P/E ratio provides an overall picture of how much investors pay for a stock compared to the earnings a company generates per share, which is one of the vital indicators in the equity financing market. For instance, if a company’s P/E ratio is 15, it implies the particular company’s stock cost is 15 times the annual profit it makes on a per-share basis. It is one of the quickest and simplest ways to determine whether a company is undervalued or overvalued.

How to Calculate P/E Ratio?

To calculate the P/E ratio, simply divide the company’s current stock price by its EPS (Earnings Per Share).

P/E Ratio = Stock Price Per Share or Market Price Per Share / EPS

whereabout, EPS is calculated as:

EPS = Net Profit / Number of Equity Shares

And Number of Equity Shares as,

Number of Equity Shares = Paid Up Capital / Face Value

Suppose, the current market price per share of company X is $100 and its EPS is $10. As a result, P/E Ratio = ($100/$10) = 10. Hence, the P/E Ratio of a company X is 10, which entails that investors are willing to pay $10 for every dollar of the company’s earnings.

You May Also Like:

6 Financial Ratios To Look Into Before Investing In Stocks

How To Analyze A Stock/Company For Investment?

P/E Ratio Example

Let’s refer to a hypothetical example I set up. Imagine as if we are currently assessing two companies: company X and company Z. Suppose, the stock of company X is currently trading at $500 and that of company Y at $300. If we just take a simple glance at both company’s current stock prices, company X seems expensive. Right? But not necessarily, as the stock price alone does not help in determining whether a company is expensive or not. This is where the P/E ratio comes into play.

Now, let us assume the industry’s average P/E is 20 and similarly, when we calculated the P/E ratio of an individual’s stock, we found it to be 20 for company X and 30 for company Z. From it, we can clearly see that company Z actually is found to be expensive in terms of P/E which is exactly opposite if we take a look at current stock price only. Hence, despite the company’s X stock price being higher than company Z, however, in terms of valuation, company X is cheaper, as you pay less for $1 of current earnings for company X when compared to company Z.

It is also to be noted down that company Z has a higher ratio than both industry average and company X. This means that investors are expecting higher earnings growth for company Z in the future compared to the market, as a result, they are willing to pay more for per dollar earnings. Hence, the P/E ratio is just one of the many indicators for the valuation purpose to guide us in our investment journey, so it shouldn’t be the only indicator to impact our investment decision. Instead, other indicators along with the P/E ratio can be taken into consideration for fruitful investment decisions in the market. A perfect example that can be considered when it comes to way higher P/E Ratio is Tesla, as its P/E ratio as of January 21, 2022, is 305.47. It is only because of the humongous potential for growth of Tesla in the coming days as electric cars are the means for a sustainable environment in the coming days to reduce the impact of carbon-emission vehicles. It is due to this, investors pay more to grab the stock of Tesla.

Variants of P/E Ratio

Trailing P/E

The trailing P/E ratio also known as trailing twelve-month earnings (TTM) is calculated by using the company’s earnings over the last 12 months. Taking the past earnings into consideration, we are taking the actual and the reported data for our evaluation purpose. Trailing P/E is used by popular investment apps like Robinhood and financial websites like Yahoo Finance and Google Finance.

Forward P/E

Exactly opposite of Trailing P/E, Forward P/E takes the estimation of the company’s future earnings into consideration. It doesn’t use the reported data; however, it utilizes the best possible information available in order to ascertain how a market can perform in the coming years.

The Shiller P/E

The Shiller P/E is calculated by dividing the price by the average earnings of the last 10 years, adjusted for inflation. It is one of the widely used measures to evaluate the valuation of the market indices like the S&P 500 index.

The Analysis of High, Low, Justified and Negative P/E Ratio

High P/E Ratio

Generally, growth stocks are the ones that depict a high P/E ratio. It is because investors have higher expectations of future growth earnings for such stocks and are willing to pay more. As a result, they are considered to be overvalued stocks. There is a lot of pressure for the companies to deliver better in order to justify their higher valuation in the stock market and they are the ones, which are considered riskier investments as well.

Low P/E Ratio

Stock with a low P/E Ratio is considered to be undervalued. However, before investing in undervalued stocks with the hope of booking a higher profit margin, you need to figure out whether the company you are going to invest in, is strong on its fundamentals or not. If not, it will be your poor investment decision for sure. However, if you are able to find out the undervalued stocks with strong fundamentals, it will be one of your best investments ever as you will be reaping substantial profits over the period.

Justified P/E Ratio

Justified P/E is calculated quite differently than the standard P/E as it takes factors like expected dividend, required rate of return, and expected growth rate of dividends into consideration. Hence, the two ratios: justified P/E and the standard P/E produce two varied results. However, an investor can leverage from both ratios by comparing them. If the standard P/E ratio is lower than the justified P/E ratio, it indicates the stocks are undervalued and vice-versa.

Negative P/E Ratio

A negative P/E Ratio is obvious, it is when the company experiences net losses over the period. Well-established companies too might experience net losses, due to the factors out of their control. For instance, COVID-19 impacted a lot of companies that were doing quite well before its arrival. However, you need to analyze whether the company is experiencing a negative P/E ratio on some of the quarters only or is it showcasing such financial outcomes on a back-to-back basis. If the second scenario prevails, it depicts a high probability of going bankrupt as well. Hence, it’s all up to you how you analyze the company based on its P/E ratio before performing some sort of investment.

Major Factors Affecting the Stock Prices

Absolute and Relative P/E Ratio

The absolute P/E ratio is calculated by dividing the current stock price by the trailing EPS. On the other hand, the relative P/E compares the absolute P/E to a benchmark such as the past 10 years. Let’s get it clearer through an example. Suppose a company’s P/E ranged from 25 to 45 over the past 10 years. If that particular company’s absolute (current) P/E is 30, the absolute P/E to the lowest value of the past 10 years is 1.2 (30/25), and the absolute P/E to the highest value of the past 10-year range is 0.67 (30/45). Hence, it gives investors an overall idea that the company’s current P/E ratio is presently 67% of the 10-year high and 20% higher than the 10-year low.

Comparison of Companies Based on P/E

Before you proceed to compare the companies based on the P/E ratio, you need to know that it is irrational to compare the companies of different industries. It is because different industries have different P/E Ratio averages. Hence, what you need to do is, compare the companies that fall under the same industry/sector.

In the context of Nepal, let’s take the two banks that fall under the ‘Commercial Bank’ sector: NIC Asia and Nabil Bank. As per the second quarter of the fiscal year 2078/79, the P/E ratio of NIC Asia Bank is 21.19, whereas that of Nabil bank is found to be 47.06. It can be easily concluded that the stock of Nabil bank falls under quite an expensive side, however, it cannot be denied the fact that Nabil Bank is strong on its fundamentals and is providing higher dividends on an annual basis than NIC Asia Bank.

Different sectors/industries have different working mechanisms thereby leading to variation in terms of investors’ perception of their willingness to pay. A bank operates quite differently than the hotel sector, which is obvious. Hence, it’s not a big deal if they depict different P/E ratio averages. Before investing in any of the companies, you need to figure out the sector that particular company falls under, compare it with the sector’s P/E Ratio average, and determine whether it surpasses or lags behind the sector’s P/E average to figure out the true valuation of the company you are going to invest in.

How to Use a P/E Ratio?

To assess value and the growth stocks. For value stocks, find out the companies with low P/E ratios (undervalued stocks) whereas, you need to consider the companies with high P/E ratios (overvalued) in order to find out the growth stocks.
For the comparison purpose of one stock with another falling under the same sector or to compare the stocks with whole market indices such as S&P 500 or NEPSE.
To compare a stock’s current value to the projected future value or its past value.
As the company’s stock price itself tells you nothing about its valuation, you should consider the P/E ratio before delving into your investment.

What is a Good P/E Ratio?

There is no definite measure of the P/E ratio to determine whether it is good or bad. It depends on the industry under which a company is operating, and the P/E ratio varies per industry. Some industries might possess a higher average P/E ratio while others might have a lower P/E ratio. A high P/E ratio may necessarily not be bad because the investors might take the company as the one with higher future earnings potential. Further, if you are able to find a company with a lower P/E ratio along with strong fundamentals, it is another perfect opportunity to invest in. Hence, instead of figuring out the good and bad P/E ratio, you need to find out the opportunity to invest in both undervalued (value stocks) as well as overvalued (growth stocks). For instance, you can invest in the stocks of Bank of America (the value stock) and in companies like Tesla, Amazon (growth stocks) too.

P/E Ratio and Value Investing

Value investors consider the intrinsic value of underlying assets of a company rather than the market price the stock is currently trading on. Hence, the P/E ratio is one of the major metrics to assist investors in order to uncover the value stocks. P/E ratio helps value investors to discover the undervalued stocks, as a result, they buy the stocks at a lower price than their intrinsic value and sell them at a higher rate when their price rises. However, to leverage fully from value investing requires the long-term holding of stocks so that the power of compounding could circulate on the stocks you have held for so long.

Growth Investing Vs. Value Investing: Comparing Strategies

P/E Ratio and Earnings Yield

Earnings Yield is the inverse of the P/E ratio due to which it is calculated by dividing EPS by the current stock price, expressed as a percentage. Earnings Yield is not widely used like P/E ratio when it comes to the selection of metric deciding investor’s decision. However, it is a very useful metric when a company possesses negative earnings. It is because the P/E ratio will be denoted as N/A due to negative EPS because of the net losses of the company, however, earnings yield can be calculated, no matter it will be obtained in the negative figure, which becomes vital for comparison basis at the end.

Limitations of P/E Ratio

It is not recommended to rely on a single or few indicators for your investment decision. You should always analyze the external factors impacting the contemporary context basically by analyzing what is going on in the outside world and the economic trends. P/E Ratio has drawbacks too, like many other financial ratios which are listed down below.

The P/E ratio does not indicate whether a company’s cash flow is going to incline or decline in the coming years.
It does not take the debt aspect of the company into consideration.
It only takes the EPS of a company into account, however, disregards the EPS growth rate of the company. It is due to which many investors prefer the PEG ratio over the P/E ratio.
The net profit or earnings of the company gets unveiled on a quarterly basis, where the market price of stocks fluctuates on a daily basis.
P/E Ratio is not applicable for unprofitable companies. For instance, the startup companies.
As companies can manipulate the earnings, it may mislead the investors negatively impacting their decision-making.

From The Author:

Buy and Hold Investment Strategy: Explained

Dollar Cost Averaging: How it Can Be an Effective Strategy in Stock Investing?

(Liked this article??? If you are also interested in publishing your articles related to business, finance, and economics, then mail us your article at Investopaper@gmail.com.)