What Is Price/Earnings (P/E) Ratio?

What Is Price/Earnings (P/E) Ratio? 

Price/Earnings (P/E) is a valuation metric based upon the expected future earnings of the company as perceived by the market. Expressed as a price multiple of the Earnings Per Share (EPS), the multiple represents the number of years of today’s earnings it would take for the company to equate to its perceived present market value. The higher the multiple, the higher the premium investors are willing to pay per dollar of EPS.

Simply put, P/E ratio is computed as follows: 

If a company were to earn $1 per share with its share trading at $15, its P/E ratio is $15/$1 = 15 times.

Historical P/E

Typically the reported P/E ratio of a company is the historical P/E ratio. This is based on the EPS reported for the past financial year. Since the EPS does not change until the end of the next reported financial year, a disadvantage of the historical P/E ratio is that it will not accurately reflect the valuation of the company.

In order to get a more accurate picture, some analysts turn to the rolling P/E ratio. The rolling P/E ratio is still calculated based on the historical financials, but in this case, it is based on the EPS of the last 4 financial quarters of the company.

A caveat: it should be noted that historical earnings are not representative of the company’s future earnings.

At ShareInvestor, we provide both historical and rolling P/E ratios in our Factsheet.

Forward P/E

In order to value a company, research analysts will project the earnings of a company into the future. The forward P/E ratio is derived from the projected earnings of the company and this can then serve as a basis of valuing the company. Since this is based on projections rather than factual figures, a common issue is the differences in forward P/E ratios which are reported by different research houses, since all of them make different assumptions in deriving their projections.

How do we use and interpret the P/E ratio?

Typically we use the P/E ratio of a company for comparison in the following areas:

1. Against its past performance
2. Against other companies with comparable business models
3. Against the industry or sector average

For example, if the P/E ratio of a company in the Maritime industry is 10 while the average P/E ratio of the entire Maritime industry is 7, the company may be overvalued and we will want to look at the reasons contributing to the higher valuation.

A high P/E ratio is attractive to growth investors who are willing to pay a higher premium for today’s earnings in anticipation of higher future earnings growth of the company. However the downside risk is higher as investors will have higher expectations for that stock and if the company’s future earnings do not meet the expectation of the market, the share price may fall. A case in point is the badly-hit technology stocks which were excessively priced for their growth potential during the dot-com boom at the turn of the millennium.

Unlike growth investors who view high P/E ratio stocks as attractive investments, value investors are less inclined to buy stocks which are deemed to be overpriced. Instead, value investors would prefer undervalued stocks which are trading at low P/E ratios at a bargain. It is in their belief that the market price will ultimately gravitate towards the stock’s fair value over time given the company’s growth potential.

One important point to note is that P/E ratios vary over time due to business earnings cycles and across industries as well as markets. In addition, P/E ratios of companies in mature industries tend to be lower than companies in relatively rapidly growing industries with more robust prospects. 

Where can I find the P/E ratios at ShareInvestor?

There are numerous ways for you to access the trailing P/E ratios at ShareInvestor.

1. P/E ratios for every listed company can be easily found under the Fundamental section of the Factsheet.

Source: ShareInvestor.com

The EPS and P/E are trailing ratios as derived from the actual net earnings for the last reported financial year and are adjusted for the latest number of issued ordinary shares. The Rolling EPS and Rolling P/E are trailing ratios as derived from the actual net earnings for the last reported 4 quarters or 2 half-years, where available, subsequent to the earnings release for the last financial year and are adjusted for the latest number of issued ordinary shares.

In this example, the stock’s valuation has improved slightly as the stock is trading at a higher price multiple (Rolling P/E: 12.920 which provides for a more up-to-date view of the current market sentiment as opposed to P/E: 12.793). The price-multiple range within which it is trading as compared to the P/E of the Straits Times Index (STI) nearing its historical low at 12.500 times in Year 2011 suggests that it is relatively attractive.

2. P/E ratios for the listed company over the years can be easily found under the Adjusted Fundamental Data section of the Financials.

Source: ShareInvestor.com

The stock is more costly as it is trading at a higher price multiple (P/E: 13.00 for Full Year Mar 2011) than it was a year ago (P/E: 12.73 for Full Year Mar 2010).

3. P/E for the industry can be easily found under the Sector Comparison section of the Factsheet.

Source: ShareInvestor.com

The stock (Rolling P/E: 13.089) is trading close to the industry average (Rolling P/E: 13.405), indicating it is fairly priced relative to its peers.

4. “Rolling P/E” table column layout under Prices and Portfolio.

Source: ShareInvestor.com

Source: ShareInvestor.com

There is a “Rolling P/E” column layout under Prices and Portfolio. By selecting this view, you will be able to see the Rolling P/E of a stock and compare it using a variety of filters and selection.

In addition, if you would like to have your own customised columns in your portfolio, you can also add the Rolling P/E field into your selection.

5. Fundamental filters under Prices.

Source: ShareInvestor.com

Under the Fundamental dropdown selection, the following selections are made available to you to assist you in finding swiftly the stocks with the highest or lowest P/E or Rolling P/E in the market.

– Lowest Price-Earnings (P/E) Ratio
– Highest Rolling P/E
– Lowest Rolling P/E

Are there negative P/E ratios? 

Where companies incur net losses, the resultant P/E ratio becomes negative. Negative P/E ratios are not meaningful as investors would not be able to draw valuation comparisons for such stocks against other stocks on the basis of future earnings prospects. Hence we do not show negative P/E ratios.

What are the shortcomings or caveats of P/E?

When evaluating a company’s performance, investors ought to watch out for the quality and sustainability of earnings reported according to accounting conventions as these are susceptible to assumptions, interpretations and management manipulation to meet near-term expectations.

The accounting treatment of exceptional one-time gains or losses can also distort the resulting P/E ra­tios since such non-recurrent components of earnings are not incurred in the ordinary course of business and hence have no implications on the company’s future earnings prospects.

As a rule of thumb, over the longer term, earnings should be consistent with rather than exceeding free cash flow.

Lastly, investors ought to ensure accounting policies in measuring earnings should be applied consistently across before performing any form of comparisons.

Hence, while ratio analysis can be a useful technique in evaluating a company’s financial position and performance when appropriately applied in context, the astute investors should endeavour to look beyond the numerical measurements and examine further into the underlying corporate and macroeconomic developments in the interpretation and analysis of the financial ratios. By the same token, investors should never rely on a single financial ratio in making investment decisions.