The price-to-earnings ratio, also known as P/E ratio, is a financial ratio that calculates a company’s earnings multiple, or the price multiple. It helps in comparing the company’s stock price-to-earnings per share. It gives investors a better idea of the value of the company. Apart from showing the market’s expectation, it shows the price to be paid per unit of the future or current earnings. It is also used to equate aggregate markets over time against other correlated companies within the industry.

Earnings are essential when estimating the company’s stock price as investors need to know how the company is going to make profits and get an idea of its future cash flow. The P/E ratio and the PEG ratio are the to go to metrics to best determine the stock’s violation.

If the company stagnates and the present earnings do not improve, the price-to-earnings ratio is then interpreted as the number of years the company needs to pay back the sum paid for each share.

Importance of the Price-to-Earnings Ratio

As an investor, one wants to buy a financially stable company that would give good investment returns. The P/E ratio will be among the many ratios in the research process for choosing a stock because it will tell whether they are paying a reasonable price. Companies within the same industry are grouped for ease of comparisons, regardless of the stocks varying prices. The P/E ratio is a quick method of valuing a company using earnings. It is possible to assess what kind of company or stock being dealt with using the high or the low P/E.

P/E Formula

The formula is derived by dividing the current price of a stock by the earnings from the stock. The P/E ratio tells whether the stock price matches its potential or the long term value.

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P/E= Earnings per Share

Where earnings per share (EPS) is the amount of profit allocated to each share of common stock, this represents the portion of net income that each share of common stock would receive.

Market Value per Share

The P/E ratio is usually calculated using the current stock price, although the average cost can be used over periods of time. However, when calculating the earnings part, three different approaches speak about various things concerning the stocks.

The three approaches are:

  • Forward earnings
  • Trailing twelve months (TTM) earnings
  • The Shiller P/E ratio

Forward Earnings

Also known as the estimated price-to-earnings, the P/E ratio of the company is calculated using the estimates of its future earnings. Although the forward price-to-earnings ratio is not based on the data collected, it uses the currently available information on the markets’ expectations concerning its future performance.

Trailing 12 months (TTM) Earnings

The price-to-earnings ratio of a company can also be calculated using its earnings yield over the last twelve months: trailing 12 months earnings (TTM), or the trailing twelve months earnings. The method is commonly used to evaluate companies as it factors in real data from past earnings.

Shiller P/E Ratio

The approach uses average earnings over a given period. A well-known example in this approach is the cyclical adjusted price-earnings ratio (CAP/E).

The ratio is calculated by dividing the stock price by the average earnings over the preceding ten years, adjusted for inflation, and commonly used to evaluate the S&P 500 index.

Example on How to Calculate a P/E Ratio

Let’s say one wants to invest in company XYZ shares, which currently trades in the stock market for $24 per share. If the company’s earns $4 per share, the P/E ratio would be 6.0 ($24/$6). So, the investor will have to invest $6 for every $1 in profit. It may also mean the earnings stay constant; it will take six years to get back the share price.

Therefore, when comparing stocks based on their P/E ratio, a low P/E value is more desirable than P/E with a higher value.

High Price-to-Earnings Ratio

Growth stocks are mostly associated with companies with high P/E ratio. A higher P/E signifies positive future performance; hence a higher expectations of future earning, which means investors are willing to pay more for them. The disadvantage is that growth stock is susceptible to higher volatility, thus putting pressure on companies to go the extra mile to justify their high valuation. This, therefore, suggests that investing in growth prospect stock is risky. Stocks with high P/E ratios are sometimes considered overvalued.

Low Price-to-Earnings Ratio

On the other hand, value stocks are associated with companies with low price-to-earnings ratio. They are considered undervalued since their stock price trade at a low price. The undervaluing acts as a bargain and prompt investors to buy more stocks before changes to the pricing are made. Thus, investors make a profit due to high stock prices when the markets correct the underpricing. Mature businesses that pay steady rates of dividends are examples of low P/E stock.

Advantages of Using the P/E Ratio

Investors can determine whether shares are overvalued or undervalued and make informed choices when choosing the stocks to purchase. On behalf of the company, the P/E ratio is a useful tool in gauging investor expectations in the business.

Disadvantages of Using the P/E Ratio

The P/E ratio has its limitations; hence, it should not be used single-handedly as a tool to measure a company’s value. The rate does not mean much until it is equated to other companies’ ln the same catalog or stocks in the same division.

The price-to-earnings ratio, also referred to as a P/E ratio, is a method of valuing a company. The ratio is calculated by dividing the company’s market per value share by the earnings per share. A higher price-to-earning ratio shows an expectation of high levels in future dollar of earnings, as well as strong growth. On the other hand, a low price-to-earnings ratio indicates that the current earnings surpass past trends or the company is undervalued.

It is a noble idea for investors to understand the price-to-earnings ratio and how to apply it in evaluating the price of shares. However, it shouldn’t be used on its own and should be used in comparing companies in different industries. Although it has its imperfections, the P/E ratio is still the most acceptable method of evaluating a potential investment decision.

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Chris Douthit
Chris Douthit

Chris Douthit, MBA, CSPO, is a former professional trader for Goldman Sachs and the founder of OptionStrategiesInsider.com. His work, market predictions, and options strategies approach has been featured on NASDAQ, Seeking Alpha, Marketplace, and Hackernoon.