Explaining the price to earnings ratio – Part 1

The Price to Earnings (PE) Ratio is one of, if not, the most often used valuation metric. Many investors rely heavily on the PE ratio when deciding whether or not they should purchase a particular stock. There are even some investors who utilise only the PE ratio, devising various strategies around the metric. In this article, we are going to discuss the PE ratio in full. We will look at how it is calculated and why it is so significant to investors. Next, we will look at what the PE ratio really tells investors and highlight two reasons why we should take PE ratios with a grain of salt.

PE ratio calculation

The PE ratio is a relative valuation metric that investors use to gauge whether a stock is overvalued or undervalued. The PE ratio is calculated by dividing a company’s stock price by the company’s earnings per share, its EPS. The EPS can be found on the company’s income statement from the Audited Financial Statements or the company’s Annual Report (10K). If it is not there, then you can calculate it by taking the company’s net income and dividing it by the number of shares in issue for that period.

There are two different types of PE ratios, the forward PE ratio, and the trailing PE Ratio.  The difference between them is that the trailing PE Ratio is a historic value while the forward PE ratio is a forward-looking value. What does this mean? By historic, we mean that the trailing PE ratio is calculated using the company’s earnings for the last 12 months. On the other hand, the forward PE ratio is calculated using the expectations for the current financial year. In other words, it is calculated using the total earnings that the analyst expects the company to record for the current financial year.

To calculate the forward PE ratio, the investor would have to come up with an estimate for the earnings in the current year and then divide the current stock price by that value. This is not as easy as it might sound since there are a lot of factors that an analyst or investor will need to consider when trying to estimate earnings. These factors vary greatly and can include such things as tax breaks, new tax penalties, litigation expenses, etc. The investor will also have to consider the effects that going into new markets, expansion, acquisitions, and so on will have on the company. Furthermore, each of these factors could affect the company’s earnings in either a positive or negative way.

The importance of the PE ratio to investors

Now that we understand what the PE ratio is and how to calculate it, let’s talk about why the PE ratio is so important to Investors. Remember I said earlier that the PE Ratio is a relative valuation method? Well, that is the first reason it is so important to investors. It is a valuation method. In other words, Investors use it as a way to determine whether a stock is undervalued, fairly valued, or overvalued.

Generally, a low PE ratio is taken to mean that a stock is undervalued, and a high PE is taken to mean that the stock is overvalued. However, there is no clear-cut number that can be applied to all stocks when it comes on to the PE ratio. In fact, one stock can have a significantly higher PE ratio than another and still be a better bargain. I am going to explain this a bit further when I talk about why investors should take the PE ratio with a grain of salt.

In my opinion, the general suggestion of buying stocks with low PE ratios is somewhat incomplete. I believe, it is more accurate to say that for two similarly sized companies, operating in the same sector, with similar operations, the one with the lower PE ratio is more attractively priced.

Let me explain using an example. Let’s say we have two companies, COMPANY A and COMPANY B, each with a market cap of $1 billion (so similarly sized) and both in the toilet paper manufacturing business. We can compare the PE ratios of these companies.

Let’s say Company A has a stock price of $10 per share and an EPS of $0.50, its PE is 20X. And, let’s say Company B has a stock price of $30 per share and an EPS of $3.00. Company B’s PE ratio would be 10X. If both companies have similar operations and are growing at the same rate, then the one with the lower PE ratio is cheaper. Company B would be the better investment based on the PE ratio method of valuation despite having a higher stock price. In fact, Company A would be two times as expensive based on this metric.

More on the PE ratio next week.

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