“Is a company with a low P/E a better bet than one with a high one?” It’s a question I’ve heard in one form or another quite a lot over the years, and the simple answer is “Other things being equal, yes”. But, of course, other things are never equal. Simple though it is to calculate, the Price to Earnings ratio can be quite a tricky number to divine much useful information from.
What is the P/E ratio?
As the name suggests, the price-to-earnings ratio compares the net profit of a company to its share price. And it tells the investor how many years it would take for them to regain their invested capital if the underlying business’ earnings don’t change moving forward. But there are lots of different ways to interpret and use this information, so let’s break things down.
The ‘P’ part simply means ‘Price’, which is just the current share price. On its own, a share price is meaningless and only takes on any meaning in the light of the actual financial performance of the company — a company that’s making more profit is going to be worth more than a company making less (again, other things being equal). And that’s where the ‘E’, or ‘Earnings’, part comes in.
If we look at a company’s accounts, the top line figure is its turnover, the amount of money it actually takes in over the course of a trading year. From that, we need to deduct all sorts of outgoings — costs of raw materials and labour, factory rentals, interest paid on borrowings, depreciation, tax, and numerous other things.
Whatever we are left with after all of that is the money that the company actually gets to keep — its earnings. Typically, some will be paid out as dividends, and some will be re-invested to grow the business, but it represents the bottom line regarding the money the company has earned for you.
And if that bottom line profit is divided between the number of shares in existence, what you get is the ‘Earnings Per Share’ (EPS) figure, which is the ‘E’ in ‘P/E’.
Price-to-Earnings Ratio = Share Price / EPS
Alternatively, investors can use non-per-share figures in the calculation, which will give the same result.
Price-to-Earnings Ratio = Market Capitalisation / Net Income
How to calculate the P/E ratio
Let’s look at an example.
Let’s say ABC Plc trades at a share price of 100p. And following its latest annual report, the company has generated an EPS of 20p for shareholders. Dividing 100p by 20p shows that the company is valued at five times its earnings. In other words, it has a P/E ratio of 5.0.
Using the alternative formula, ABC Plc has a market capitalisation of £500m and reported a net income of £100m. Once again, the price is divided by the earnings (£500m / £100m), translating into the same P/E ratio of 5.0.
Forward vs Trailing
So far, we’ve seen the P/E ratio being used on a trailing basis. Typically, whenever a P/E ratio is reported by financial media or on market data websites, it’s also reported on a trailing basis. In simple terms, that means the ratio is calculated using historical earnings.
However, the P/E ratio is also sometimes calculated on a forward basis, which means using future forecast earnings. Usually, the forecast period is over the next 12 months, but there’s nothing stopping investors from going further.
Using the Forward P/E ratio has a few advantages. The most significant is that it considers a company’s growth potential and could reveal hidden buying opportunities.
For example, XYZ Plc currently has a share price of 100p, but due to a temporary disruption in supply chains, earnings came in at just 2p per share. On a trailing basis, this puts the P/E ratio at an enormous 50.
However, prudent investors know that the disruptions to profits will be fixed next year and anticipate earnings to quickly recover to 10p per share. As such, on a forward basis, the stock is actually trading at five times earnings – far cheaper.
Unfortunately, the forward P/E ratio is far from perfect. Whenever forecasts enter the picture, it opens the door to inaccuracy, bias, and miscalculation. Suppose the forecast for XYZ earnings proves incorrect? In that case, investors may not end up with the bargain they expect. And if earnings go down even further, they may have fallen into a classic value trap.
What is the Justified P/E ratio?
Another variation of the price-to-earnings ratio is the Justified P/E ratio. This metric is trickier to calculate but can provide some valuable insight in determining whether a stock is over or undervalued.
The Justified P/E ratio looks at a firm’s dividends, earnings growth rate, and an investor’s required rate of return to estimate the P/E ratio that an investor should pay when buying shares.
Justified Trailing Price-to-Earnings Ratio = ((D / E) × (1 + g)) / (r – g)
Justified Leading Price-to-Earnings Ratio = (r – g) / (1 + g)
Where:
- D = Dividends per share just paid
- E = Earnings per share
- g = dividend growth rate
- r = investor’s required rate of return
Let’s go back to ABC Plc as an example. We already know the stock trades at a trailing P/E ratio of 5.0, as calculated earlier. But what P/E ratio should it be trading at based on the Justified ratio?
Digging into the financial statements, we can see that dividends per share currently sit at 2p and have been growing at an average of 8% per year over the last five years. If an investor has a 10% required rate of return, that means the Justified P/E ratio of ABC is 5.4. That suggests that shares of ABC Plc are currently trading at a slight discount.
The Justified P/E ratio is a useful tool. But it also has its limitations. It requires a company to pay dividends, which isn’t always the case. And furthermore, if the growth rate exceeds an investor’s required rate of return, the formula will produce a negative value. Sadly, negative values are useless, as we’ll discuss shortly.
Is a negative P/E Ratio bad?
A share price can never enter into negative territory. Once it reaches zero, the underlying business is worthless and has likely collapsed. However, the same isn’t true for earnings. There are plenty of unprofitable enterprises on the stock market, many of which have stayed that way for years.
In the long run, staying unprofitable isn’t sustainable as it requires constant capital injections either through debt or equity financing. However, in the short-to-medium term, businesses can stay afloat by investing capital into growth and expansion.
Unfortunately, when earnings are negative, so is the P/E ratio. And since a stock price can’t fall below zero, a negative P/E ratio is entirely meaningless in terms of valuation. That’s why most unprofitable companies which report a P/E ratio will often display N/A instead.
What is a healthy P/E ratio range?
As a relative valuation metric, the P/E ratio by itself doesn’t provide much information. It’s only after an investor compares it to a particular benchmark that they determine whether a stock offers good value or not.
We’ve already explored one such benchmark – the Justified P/E ratio. However, there are others. Some analysts compare a stock’s P/E ratio to that of a benchmark index such as the FTSE 100 or S&P 500. Alternatively, it can be compared to the average P/E ratio of a group of peers or the industry in which the firm operates in.
Whenever a firm’s P/E ratio is greater than the benchmark, it suggests the stock is currently overvalued. On the other hand, if the metric sits below the benchmark, then it suggests shares are undervalued, creating a buying opportunity for value investors.
Why the variation?
Why should a company be worth more than it earns? And why is there so much variation between different companies?
Well, firstly, when you buy a company’s shares, you don’t only get an entitlement to one year’s worth of earnings; what you get is all future earnings, too, and the price of the share should reflect the value of all that future dosh.
So, with ABC Plc, a P/E ratio of 5.0 will take five years to pay back its share price. So, the P/E figure is the answer to the question, “How many years will it take for earnings to repay the share price if earnings remain the same?”.
And it’s the “if earnings remain the same” bit that leads to different shares having different P/E ratios because investors will value shares more highly if a company is expected to increase its earnings year after year.
Suppose ABC Plc is expected to earn 20p this year, 35p next year, and 45p the year after instead of just 20p for the next five years? In that case, it will have earned its keep in three years instead of five. That would make it a more desirable share, and investors would be willing to pay more for it, increasing the price and leading to a higher P/E ratio.
A measure of growth
A company’s P/E can be seen as an indication of the expected future growth in its earnings per share. Companies with higher growth forecasts should, therefore, have higher P/E values, while companies with lower growth forecasts should have lower P/E values. And we would also expect companies with similar earnings forecasts to have similar P/E values, would we not? Surely, the actual nature of the business is irrelevant if the expected growth is the same, isn’t it?
In reality, we will often find shares in different sectors (or even the same sector) on very different P/E ratios, even if their earnings forecasts are similar.
Sometimes, such differences are rational, with, for example, some companies and sectors being considered riskier. But other times, it can be irrational and based on sentiment, greed, fear, ‘herd’ behaviour, and all manner of human failings. And that’s where the opportunities lie for rational investors.
What are the limitations?
Like all metrics in an analyst’s toolkit, the P/E ratio is far from perfect. And there are several limitations that investors must be aware of to avoid misuse.
For starters, a company’s debt is not taken into consideration. A stock may look cheap on an earnings multiple perspective. However, that may be due to an overleveraged balance sheet that other investors are avoiding due to a higher level of risk.
Another problem is the quality of earnings is not considered. A business could be fortunate to have an enormous windfall that sends profits through the roof and the P/E ratio tumbling into bargain territory. However, if those profits were only a one-time occurrence and not sustainable, then a cheap P/E ratio could be highly misleading.
The P/E ratio also doesn’t consider cash flow. Due to quirks of accounting, there are plenty of ways for a business to report a profit despite not actually receiving any money from customers. A classic example is with real estate investment trusts.
When interest rates fall, property values increase, pushing the value of a REIT’s asset portfolio up. This is reported as a gain on the income statement despite no money changing hands, pushing the P/E ratio down to make the stock look cheaper than it actually is. The opposite is also true. When property values fall, a loss is reported, making a stock look more expensive than it actually is.
Lastly, the P/E ratio is fairly useless when comparing the valuation of two businesses operating in separate industries or sectors.
Alternative valuation ratios
The P/E ratio is not the only valuation metric investors can use to analyse a stock. Others include: