P/E ratio

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In finance, the P/E ratio of a stock (also called its "earnings multiple", or simply "multiple", "P/E", or "PE") is used to measure how cheap or expensive share prices are. It is probably the single most consistent red flag to excessive optimism and over-investment. It also serves, regularly, as a marker of business problems and opportunities. By relating price and earnings per share for a company, one can analyze the market's valuation of a company's shares relative to the wealth the company is actually creating. A P/E ratio is calculated as:

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The price per share (numerator) is the market price of a single share of the stock. The earnings per share (denominator) is the net income of the company for the most recent 12 month period, divided by number of shares outstanding.

The P/E of a stock describes the price of a share relative to the earnings of the underlying asset. The lower the P/E, the less you have to pay for the stock, relative to what you can expect to earn from it. The higher the P/E the more over-valued the stock is.

For example, if stock A is trading at $24 and the Earnings per share for the most recent 12 month period is $3, then the P/E ratio is 24/3=8. Stock A said to have a P/E of 8 (or a multiple of 8). Put another way, you are paying $8 for every one dollar of earnings.

The main reason to calculate P/Es is for investors to compare the value of stocks, one stock with another. If one stock has a P/E twice that of another stock, it is probably a less attractive investment. But comparisons between industries, between countries, and between time periods are dangerous. To have faith in a comparison of P/E ratios, you should be comparing comparable stocks.

Normally, stocks with high earning growth are traded at higher P/E values. Say, Stock A may earn $6 per share the next year. Then the future P/E ratio is $24/6 = 4. i.e. you are paying $4 for every one dollar of earnings which is more attractive.

Contents

1 Determining share prices
2 Dividend Yield
3 The Averages
4 The Market P/E
5 An example
6 Inputs
7 The P/E concept in business culture
8 Related concepts
9 See also
10 External links

10.1 Data

Determining share prices

Share prices in a public quoted company is determined by market supply and demand and thus depends upon the expectations of the buyers and sellers of many factors, amongst these:

The company's future and recent performance
New product lines
Prospects for companies of this type, the "market sector"
Prevailing moods & fashions.

By dividing the price of one share in a company by the profits earned by the company per share, the P/E ratio is arrived at. If earnings move up in line with share prices (or vice versa) the ratio stays the same. But if stock prices gain in value and earnings remain the same or go down, the P/E rises. For example, if a stock price was $70 per share and it got $2 in earnings, the P/E is 35, historically high.

The price used to calculate a P/E ratio is usually the most recent price. The earnings figure used is the most recent available but this figure is often a year old and does not necessarily reflect the current position of the company.

Various interpretations of a particular P/E ratio are possible:

0-13 Either the stock is undervalued or the company's earnings are thought to be in decline.
14-20 For many companies a P/E ratio in this range may be considered fair value.
21-28 Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published.
28+ A company whose shares have a very high P/E either really does have an exceptionally rosy future or the stock may be the subject of a speculative bubble.
N/A A company with no earnings has an undefined P/E ratio.

0-13	Either the stock is undervalued or the company's earnings are thought to be in decline.
14-20	For many companies a P/E ratio in this range may be considered fair value.
21-28	Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published.
28+	A company whose shares have a very high P/E either really does have an exceptionally rosy future or the stock may be the subject of a speculative bubble.
N/A	A company with no earnings has an undefined P/E ratio.

P/E ratios tend to rise and fall in line with current and anticipated interest rates and investment returns available elsewhere. If the prevailing bank interest rate rises then one would expect P/E ratios to decline because some investors and speculators may choose to invest in cash rather than shares. A P/E ratio of 25 corresponds to a 4% return on investment [ROI], so if the risk-free interest rate is at or above this level there is little point in investing in a stock at a 25 P/E. Investors often choose to take a lower ROI by investing in shares in a company with some future growth potential.

Normally, the lower the (real) rates, the higher the P/Es. Stock prices are "interest rate-sensitive".

Dividend Yield

Publicly traded companies often make periodic quarterly or yearly cash payments to their owners, the shareholders, in direct proportion to the number of shares held. By law such payments can only be made out of current earnings or out of reserves (earnings retained from previous years). The company decides on the total payment and this is divided by the number of shares. The resulting dividend is an amount of cash per share. The dividend yield is the dividend paid in the last accounting year divided by the current share price.

If a stock paid out $5 per share in cash dividends to its shareholders last year and its price is currently $50, then it has a dividend yield of 10%.

Historically, at severely high P/E ratios (such as over 100x), a stock has NO (0.0%) or negligible dividend yield. With a P/E ratio over 100x, and supposing a portion of earnings is paid as dividend, it would take over a century to earn back the purchase price. Such stocks are extremely overvalued, unless a huge growth of earnings in the next years is expected.

The Averages

The average U.S. equity P/E ratio is usually around 14, meaning it takes about 14 years for a company you purchase to earn back your full purchase price for you. Average P/E over the entire market is a good indicator of overall market strength.

The Market P/E

To calculate the P/E ratio of a market index such as the S&P500, it is not accurate to take the "simple average" of the P/Es of all stock constituents. The preferred and accurate method is to calculate the weighted average. In this case, each stock's underlying market cap (price multiplied by number of shares in issue) is summed to give the total value in terms of market capitalization for the whole market index. The same method is computed for each stock's underlying net earnings (earnings per share multiplied by number of shares in issue). In this case the total of all net earnings is computed and this gives the total earnings for the whole market index. The final stage is to divide the total market capitalization by the total earnings to give the market P/E ratio. The reason for using the weighted average method rather than 'simple' average can best be described by considering a recessionary period of the economic cycle, where a number of stocks would be reporting a loss. For example, a company with a share price of $100, may have made a slight loss of say 10 cents giving a P/E ratio of -1000 (100/0.1). In another case, a company with a share price of $1 may have made a serious loss of 50 cents giving a P/E ratio of - 2 (1/0.5). This mathematical anomaly would create a misrepresentation of the underlying company losses on the overall market index.

An example

An easy and perhaps intuitive way to understand the concept is with an analogy:

Let's say, I offer you a privilege to collect a dollar every year from me forever. How much are you willing to pay for that privilege now? Let's say, you are only willing to pay me 50 cents, because you may think that paying for that privilege coming from me could be risky. On the other hand, suppose that the offer came from Bill Gates, how much would you be willing to pay him? Perhaps, your answer would be at least more than 50 cents, let's say, $20. Well, the price earnings ratio or sometimes known as earnings multiple is nothing more than the number of dollars the market is willing to pay for a privilege to be able to earn a dollar forever in perpetuity. Bill Gates's P/E ratio is 20 and my P/E ratio is 0.5.

Now view it this way: The P/E ratio also tells you how long it will take before you can recover your investment (ignoring of course the time value of money). Had you invested in Bill Gates, it would have taken you at least 20 years, while investing in me could have taken you less than a year, i.e. only 6 months.

If a stock has a relatively high P/E ratio, let's say, 100 (which Google exceeded during the summer of 2005), what does this tell you? The answer is that it depends. A few reasons a stock might have a high P/E ratio are:

The market expects the earnings to rise rapidly in the future. For example a gold mining company which has just begun to mine may not have made any money yet but next quarter it will most likely find the gold and make a lot of money. The same applies to pharmaceutical companies — often a large amount of their revenue comes from their best few patented products, so when a promising new product is approved, investors may buy up the stock.
The company was previously making a lot of money, but in the last year or quarter it had a special one time expense (called a "charge"), which lowered the earnings significantly. Stockholders, understanding (possibly incorrectly) that this was a one time issue, will still buy stock at the same price as before, and only sell at at least that same price.
Hype for the stock has caused people to buy the stock for a higher price than they normally would. This is called a bubble. One of the most important uses for the P/E metric is to decide whether a stock is undergoing a bubble or an anti-bubble by comparing its P/E to other similar companies. Historically, bubbles have been followed by crashes. As such, prudent investors try to stay out of them.
The company has some sort of business advantage which seems to ensure that it will continue making money for a long time with very little risk. Thus investors are willing to buy the stock even at a high price for the peace of mind that they will not lose their money.
A large amount of money has been inserted into the stock market, out of proportion with the growth of companies across the same time period. Since there are only a limited amount of stocks to buy, supply and demand dictate that the prices of stocks must go up. This factor can make comparing P/E ratios over time difficult.
*Likewise, a specific stock may have a temporarily high price when, for whatever reason, there has been high demand for it. This demand may have nothing to do with the company itself, but may rather relate to, for example, an institutional investor trying to diversify out risk.

Inputs

In practice, decisions must be made as to exactly how to specify the inputs used in the calculations. Does the current market price accurately value the organization? How is income to be calculated and for what periods? How do we calculate total capitalization? Can these values be trusted? What are the revenue and earnings growth prospects over the time frame one is investing in? Was there special one time charges which artificially lowered (or artificially raised) the earnings used in the calculation, and did those charges cause a drop in stock price or were they ignored? Were these charges truly one-time, or is the company trying to manipulate us into thinking so? What kind of P/E ratios is the market giving to similar companies, and also the P/E ratio of the entire market?

A distinction has to be made between the fundamental (or intrinsic) P/E and the way we actually compute P/Es. The fundamental or intrinsic P/E examines earnings forecasts. That is what was done in the analogy above. In reality, we actually compute P/Es using the latest 12 month corporate earnings. Using past earnings introduces a temporal mismatch, but it is felt that having this mismatch is better than using future earnings, since future earnings estimates are notoriously inaccurate and susceptible to deliberate manipulation.

A Low P/E does NOT necessarily mean that the stock is UNDERVALUED

Merely because a stock is trading at a low P/E is not an indicator that the stock is undervalued. A stock may be trading at a low P/E because the investors are less optimistic about the future earnings from the stock.

The P/E concept in business culture

The P/E ratio of a company is a significant focus for management in many companies and industries. This is because management is primarily paid with their company's stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders), in order to increase the stock price. The stock price can increase in one of two ways: either through improved earnings or through an improved multiple that the market assigns to those earnings. As mentioned earlier, a higher P/E ratio is the result of a sustainable advantage that allows a company to grow earnings over time (ie, investors are paying for their peace of mind). Efforts by management to convince investors that their companies do have a sustainable advantage have had profound effects on business:

The primary motivation for building conglomerates is to diversify earnings so that they go up steadily over time.
The choice of businesses which are enhanced or closed down or sold within these conglomerates is often made based on their perceived volatility, regardless of the absolute level of profits or profit margins.
One of the main genres of financial fraud, "slush fund accounting" (hiding excess earnings in good years to cover for losses in lean years), is designed to create the image that the company always slowly but steadily increases profits, with the goal to increase the P/E ratio.

These and many other actions used by companies to structure themselves to be perceived as commanding a higher P/E ratio can seem counterintuitive to some, because while they may decrease the absolute level of profits they are designed to increase the stock price.

Related concepts

The P/E is calculated primarily for common shares, not for preferred shares. The appropriate calculation for preferreds is the preferred dividend coverage ratio.

A related concept is the "PEG ratio". This is the P/E ratio adjusted by a growth coefficient. It is sometimes used in high growth industries and new ventures. Its use is controversial.

Another practice, which is not mainstream, based on behavioral finance, is to take market behavior parameters, among which the stock image, as factors playing a part in the level and evolution of the P/E.

The P/E can be applied not only to shares, but to other assets also. Thus the P/E, comparing Price to Rental Incoming for housing, is an important measure in determining the existence or absence of Property bubbles.

External links

Data

[Yahoo! Stock screener - Sorted by "P/E"]

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