Introduction

Chances are you’ve heard the term “P/E ratio” used before. When it comes to valuing stocks, the price/earnings ratio is one of the oldest and most frequently used metrics.

Although a simple indicator to calculate, the P/E is actually quite difficult to interpret. It can be extremely informative in some situations, while at other times it is next to meaningless. As a result, investors often misuse this term and place more value in the P/E than is warranted.

In this notes, we’ll introduce you to the P/E ratio and discuss how it can be used in security analysis and, perhaps more importantly, how it should not be used.

What is the P/E Ratio? P/E is short for the ratio of a company’s share price to its per-share earnings. As the name implies, to calculate the P/E you simply take the current stock price of a company and divide by its earnings per share (EPS):

P/E Ratio = Market Value per Share/Earnings per Share

Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E. However, occasionally the EPS figure comes from estimated earnings expected over the next four quarters. This is known as the leading or projected P/E. A third variation that is also sometimes seen uses the EPS of the past two quarters and estimates of the next two quarters.

There isn’t a huge difference between these variations. But it is important to realize that, in the first calculation, you are using actual historical data. The other two calculations are based on analyst estimates that are not always perfect or precise. Companies that aren’t profitable, and consequently have a negative EPS, pose a challenge when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say there is a negative P/E, others give a P/E of 0, while most just say the P/E doesn’t exist.

Historically, the average P/E ratio in the market has been around 15-25. This fluctuates significantly depending on economic conditions at the time. The P/E can also vary widely between different companies and industries.

Using the P/E Ratio Theoretically, a stock’s P/E tells us how much investors are willing to pay per dollar of earnings. For this reason it’s also called the “multiple” of a stock. In other words, a P/E ratio of 20 suggests that investors in the stock are willing to pay $20 for every $1 of earnings that the company generates. However, this is a far too simplistic way of viewing the P/E because it fails to take into account the company’s growth prospects. Growth of Earnings Although the EPS figure in the P/E is usually based on earnings from the last four quarters, the P/E is more than a measure of a company’s past performance. It also takes into account market expectations for the growth of a company. Remember, stock prices reflect what investors think a company will be worth. Future growth is already accounted for in the stock price. As a result, a better way of interpreting the P/E ratio is as a reflection of the market’s optimism concerning a company’s growth prospects.

If a company has a P/E higher than the market or industry average, this means the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop.

A good example is Microsoft. Several years ago, when it was growing by leaps and bounds, its P/E ratio was over 100. Today, Microsoft is one of the largest companies in the world, so its revenues and earnings can’t maintain the same growth as before. The result is a current P/E ratio of 43 (at the time of writing, in June 2002). This reduction in the P/E ratio is a common occurrence as high growth startups solidify their reputations and turn into blue chips.

Cheap or Expensive? The P/E ratio is a much better indicator of the value of a stock than the market price alone. For example, all things being equal, a $10 stock with a P/E of 75 is much more “expensive” than a $100 stock with a P/E of 20. That being said, there are limits to this form of analysis — you can’t just compare the P/Es of two different companies to determine which is a better value.

It’s difficult to determine whether a particular P/E is high or low without taking into account two main factors:

Company growth rates - How fast has the company been growing in the past, and are these rates expected to increase or at least continue into the future? Something isn’t right if a company has only grown at 5% in the past and still has a stratospheric P/E. If projected growth rates don’t justify the P/E, then a stock might be overpriced. In this situation, all you have to do is calculate the P/E using projected EPS.

Industry - It is only useful to compare companies if they are in the same industry. For example, utilities typically have low multiples because they are low growth, stable industries. In contrast, the technology industry is characterized by phenomenal growth rates and constant change. Comparing a tech to a utility is useless. You should only compare high growth companies to others in the same industry, or to the industry average. You can find P/E ratios by industry on Yahoo Finance.