What Is The Price-to-Earnings (P/E) Ratio?
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The price-to-earnings (P/E) ratio is an excellent metric for understanding the valuation of a company over time. It tells investors how much a company is worth. The price-to-earnings ratio measures its current share price relative to its annual earnings per share (EPS). The ratio shows how much investors will pay per share for each $1 of earnings. The P/E ratio is also called the earnings multiple or price multiple.
The price-to-earnings ratio formula is:
Stock Price Per Share / Earnings Per Share = P/E ratio
You simply divide the stock price per share (market value) by the earnings per share.
For example, if Company XYZ was currently selling at $100 per share and its annual earnings were $5 per share, its P/E ratio would be 20.
$100 / $5 = 20
Types of Price-to-Earnings Ratios
Forward P/E Ratio
The forward P/E ratio is calculated from the estimated annual earnings per share. Hence, this ratio is forward-looking and accounts for future growth. However, the forward P/E ratio is only as valid as the accuracy of the earnings estimate. Therefore, most investors use the consensus earnings estimate when determining the forward P/E ratio.
For instance, Apple (APPL) has a consensus EPS of $6.15 for 2022, according to Portfolio Insight*. This value gives a forward P/E ratio of 26.5X based on the current stock price of $163.20 (as of March 2, 2022).
The forward P/E ratio will also change if the consensus earnings estimate changes.
Some popular investing sites, like Seeking Alpha and Morningstar, use the forward P/E ratio.
Trailing Twelve Months P/E Ratio
The trailing twelve months (TTM) P/E ratio is determined from actual earnings from the past 12 months. The primary benefit of this approach is it uses real data reported in quarterly or annual earnings releases. However, the disadvantage is this ratio is backward-looking and does not factor in future growth or declining expectations.
In an example, Apple earned $5.61 per share in 2021, according to Portfolio Insight*. This value gives a TTM P/E ratio of 29.1X based on the current stock price of $163.20 (as of March 2, 2022).
The TTM P/E ratio will change each quarter as new earnings results are reported.
Other popular investing sites, like Google Finance, Yahoo Finance, and some apps use the TTM P/E ratio.
Shiller P/E Ratio
The third metric is known as the Shiller P/E ratio, also known as the cyclically adjusted price-to-earnings (CAPE) ratio or the Shiller P/E 10. This approach was developed by the Yale University Professor and Nobel Laureate Robert Shiller.
The Shiller P/E ratio adjusts the forward or TTM P/E ratio calculations. Both the standard metrics can be strongly affected by near-term changes. For instance, during COVID-19, many energy companies experienced a significant drop in revenue and had losses for several quarters. This fact caused the standard P/E ratios to become not meaningful.
The Shiller P/E ratio uses inflation-adjusted 10-year earnings data to calculate the ratio. The ratio can be determined for individual stocks but is commonly applied to indices like the S&P 500 Index. Investors can use the Shiller P/E ratio to determine if the market is overvalued or undervalued. However, one drawback for the Shiller P/E ratio is it is backward-looking.
The all-time high for the Shiller P/E ratio was 44.19X in 1999 before the dot-com crash. The current Shiller P/E ratio is 35.25X (as of March 1, 2022). The long-term average is about 17X.
Price-to-Earnings Growth Ratio
The price-to-earnings growth (PEG) ratio is a variation of the standard metrics. This ratio is calculated by dividing the company’s TTM or forward P/E ratio by the earnings growth rate over a specified period. This approach has the advantage of using the P/E ratio and an estimate for earnings growth. The main drawback is the PEG ratio uses an estimate of future earnings growth that may not be accurate.
A PEG ratio of more than 1.0 generally means a stock is overvalued, while a value less than 1.0 means a stock is undervalued.
Why Is The P/E Ratio Useful?
Investors use the P/E ratio as a tool to determine a stock’s valuation. For example, the ratio shows whether the stock is undervalued or overvalued. In addition, a P/E ratio allows analysts and investors to compare stocks fairly. For example, investors can compare a company’s P/E ratio against another company’s stock in a like-to-like comparison or compare a company against its record over time. Comparisons are typically made with companies in the same industry and at the same level of development or growth.
What Does a High P/E Ratio Mean?
If the P/E ratio is high, investors expect future high growth from the stock. However, it could also mean the stock is overvalued. If a company has a high P/E ratio, investors are paying more per share to have an ownership interest in a company’s earnings.
What is considered a high P/E ratio is dependent on the industry and specific stock. Different industries will have a diverse range of “normal” P/E ratios. Therefore, investors should compare a company’s P/E ratio within an industry for an apples-to-apples investment picture.
What Does a Low P/E Ratio Mean?
If a company’s P/E ratio is low compared to other stocks in its industry, it may be undervalued and, therefore, a good investment. However, investors should carefully look at the company’s financials and results for any warning signs causing the lower P/E ratio. For example, it could indicate that earnings may decrease in the future, debt is too high, the company is losing market share or other challenges.
Does Every Company Have a P/E Ratio?
If a company loses money or has no earnings, it doesn’t have a P/E ratio. This point is because there would be no earnings per share to divide the stock price per share. You cannot divide the market value per share by $0. So if a company has negative earnings per share or no profits, the P/E ratio would be not meaningful. A brand-new company on the stock exchange would also have a P/E ratio of NMF until it had earnings per share.
Example Comparing Two Companies
The P/E ratio is commonly used to compare similar companies as investment choices. In this example, let’s assume you have saved $10,000 in the past year and want to invest it. You are trying to build a passive income stream and live off dividends.
We now compare Coca-Cola (KO) and Pepsi (PEP) as potential investment candidates. Both stocks are known as dividend growth stocks. They are popular amongst investors for their dividends yields and consistent returns. However, which one is overvalued, fairly valued, or undervalued today. We can use the P/E ratio to help us with this determination.
In the table below, we use data from Portfolio Insight* and compare Coca-Cola and Pepsi.
Coca-Cola (KO) | Pepsi (PEP) | |
---|---|---|
Estimated EPS 2022 | $2.46 | $6.70 |
EPS 2021 | $2.32 | $6.26 |
Current Stock Price | $61.97 | $162.67 |
Forward P/E Ratio | 25.2X | 24.3X |
TTM P/E Ratio | 26.7X | 26.0X |
Average P/E Ratio Range Past Decade | 20.2X – 24.37X | 18.99X – 24.08X |
Average P/E Ratio Range Past 5-years | 23.5X – 26.44X | 22.4X – 26.2X |
Source: Data from Portfolio Insight* (as of March 2, 2022).
Based on this analysis, both stocks are slightly overvalued. Hence, an investor can conclude it is not a good time to add to existing positions or start a new one for either stock.
Disclaimer: Dividend Power is not a licensed or registered investment adviser or broker/dealer. We are not providing you with individual investment advice on this site. Please consult with ...
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