When reading about financial and real estate concepts, do you ever find yourself Googling term after term? You’re not alone. Both industries are chock full of jargon.
If you don’t have all the lingo (or math) down yet, one such concept that may still seem confusing is price-to-earnings ratio. Allow me to break it down for you.
What is Price-to-Earnings Ratio?
The price-to-earnings (P/E) ratio is a metric investors use to value a company’s stock. Stated differently, the P/E ratio tells you how many dollars in price per share investors are willing to pay for every dollar in earnings per share the company earns.
How to Calculate Price-to-Earnings Ratio
The P/E ratio is calculated by taking the price of the stock and dividing by the earnings per share (EPS) of the company. The resulting number is the P/E ratio, also referred to as the earnings multiple or simply the multiple (M).
The formula looks like this:
P / E = M
It is called a multiple because if you multiply that number by the earnings per share, you arrive at the stock price.
So, if we re-work the formula, it would look like this:
E * M = P
Take Apple, for example. The company earned $12.12 per share over the last 12 reported months.
Say the stock closed one day at $172.91 (which it did recently). The P/E ratio for Apple would be about 14.27.
$172.91 / $12.12 = 14.27
This means that, right now, investors are willing to pay $14.27 in price for every $1 the company earns.
How Are Price-to-Earnings Ratios Reported?
P/E ratios are usually reported two ways: the forward P/E and the trailing P/E. The difference is the source of the earnings used to calculate the multiple.
The forward P/E will use the earnings that the company is projecting over the next year, while the trailing P/E will use the actual earnings received over the past 12 months. You may see the latter version shown as P/E (TTM), where TTM stands for “trailing twelve months.”
Both numbers can be informative, but keep in mind that the forward P/E is based on projections that haven’t come to pass yet, while the TTM is based on actual dollars earned.
How to Use the P/E Ratio
The P/E ratio is most useful for comparing the relative value of one company’s stock to another’s or comparing it to itself over time. Some investors may argue that a higher P/E ratio is indicative of a more expensive stock and a lower P/E ratio would indicate a cheaper stock.
What’s a Good Price-to-Earnings Ratio?
Here’s an example:
Company A and Company B are in the same industry. They have a relatively similar business model. If Company A is trading at 10 times earnings and Company B is trading at 20 times earnings, the P/E ratio would suggest that Company A is the better buy because the price is lower in relation to the profits the company earns.
Another useful application of the P/E ratio is to evaluate a stock or index over time. If a stock has historically traded at 15 times earnings but is currently getting a 20 multiple, we may infer that the stock is expensive by historical measures and may not be a strong buy at the current price.
Limitations of the P/E Ratio
If it were as simple as buying stocks with the lowest multiple, we’d all have figured out this stock market thing by now. Unfortunately, there are many factors that may impact the P/E ratio and make the decision to buy, sell, or hold a stock less clear.
Earnings growth is one factor that will skew the ratio. Faster-growing companies tend to have disproportionately higher P/Es. Once their growth levels out, the P/E ratio will fall. For this reason, it’s important to consider where a company is in its life cycle in relation to its P/E.
This is why stocks are ultimately valued based on their cash flow over a very long period of time. The P/E ratio is reflective of either actual earnings, or in the case of the forward P/E, next year’s earnings. But if investors believe that a company’s long-term earnings growth will be high relative to the industry or market as a whole, they will be willing to pay a higher multiple for the stock today.
For example, Amazon’s price-to-earnings is around 80 right now. Why? Investors believe the future earning potential of the company is strong enough to warrant paying a huge premium today.
That said, there is another ratio called the price/earnings to growth (PEG) ratio that attempts to adjust for the growth of a company. The PEG ratio simply starts with the P/E ratio and then divides it by the projected growth rate of the earnings. A company with a lower PEG ratio means the company is growing its earnings faster.
The formula looks like this:
(P / E) / Annual EPS Growth = PEG
Companies in different sectors will also receive different multiples. There is no sense in comparing a utility company to a tech company with the P/E ratio.
The best-in-class company or companies in a given sector may also “deserve” a higher multiple. They are the best-run companies with the best brands and best management.
All other things equal, Walmart should get a higher multiple than Sears. Sears wouldn’t be considered a better buy based solely on having a lower multiple.
Lastly, the price-to-earnings ratio of a broader index like the S&P 500 can tell us little about the future direction of the stock market as a whole.
Looking back historically, the P/E ratio has a very low correlation with subsequent returns over a five- to 10-year period. Stocks are valued based on their cash flow potential over a very long time series, and a ratio based on one year of earnings will not be a sufficient statistic to give us any information on the long-term prospects of the market.
The price-to-earnings ratio is a useful metric for understanding a given stock’s relative value to its sector or itself over time. It should be used in context with other information to arrive at an investment decision.
Investors should be careful not to infer too much from it, especially when looking at the broader direction of the entire market.
Do you have a better understanding of the ratio and its applications now? If not, what other questions do you have?
Let me know in a comment below.