Price–earnings ratio

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In finance, the PE ratio of a stock (also called its "earnings multiple", just "multiple", or "P/E") is used to measure how cheap or expensive share prices are. It is probably the single most consistent red flag to excessive optimism and over-investment. It also serves, regularly, as a marker of business problems and opportunities. By relating price and earnings per share for a company, one can analyze the market's valuation of a company's shares relative to the wealth the company is actually creating. A PE ratio is calculated as:

The price per share (numerator) is the market price of a single share of the stock. The Earnings per share (denominator) is the Net income of the company for the most recent 12 month period, divided by number of shares outstanding.

The PE of a stock describes the price of a share relative to the earnings of the underlying asset. The lower the PE, the less you have to pay for the stock, relative to what you can expect to earn from it. The higher the PE the more over-valued the stock is.

For example, if a stock is trading at $24 and the Earnings per share for the most recent 12 month period is $3, then the PE ratio is 24/3=8. The stock is said to have a PE of 8 (or a multiple of 8). Put another way, you are paying $8 for every one dollar of earnings.

The main reason to calculate PEs is for investors to compare the value of stocks, one stock with another. If one stock has a PE twice that of another stock, it is probably a less attractive investment. But comparisons between industries, between countries, and between time periods are dangerous. To have faith in a comparison of PE ratios, you should be comparing comparable stocks.

Determining share prices

Share prices are determined by market demand and thus built on expectations of:

  • A company's future and recent performance
  • New product lines
  • Prospects for its sector

The rest will reflect prevailing moods, fashions, and sentiments.

By relating share prices to their actual profits, the P/E ratio highlights the connection between share prices and recent company performance. If earnings move up with share prices the ratio stays the same. But if stock prices gain in value and earnings remain the same or go down, the P/E rises. For example, if a stock price was $70 and it got $2 in earnings, the P/E is 35, historically high.

A P/E of:

  • 0-13 - Undervalued, cheap by historical standards. Buy stocks at this P/E.
  • 14-20 - Fair value, normal.
  • 21-28 - Overvalued. Sell stocks at this P/E.
  • 28+ - Stock market is in a speculative bubble, use extreme caution here. One perspective is that 1/28 is only about 3.57% return on money, so if the risk-free interest rate is at or above this level there is little point in investing in a stock at a 28 P/E. Conversely, however, the company may have some future growth potential.

Those brackets are only an heuristic and are debatable. In particular, the above reference to interest rates shows that an adjustment to those yardsticks is needed by taking into account the current long term interest rates, if possible deflated (= adjusted for inflation). Normally, the lower the (real) rates, the higher the P/Es. Stock prices are "interest rate-sensitive".

Current P/E of Stock market indices

Dividend Yield

Publicly traded companies often make quarterly cash payment to their owners, the shareholders. A percentage of earnings are paid out as cash dividends. This is called a dividend yield.

To calculate a dividend yield, you divide the cash paid out in dividends last year by the current stock price. For example, if a stock paid out $5 per share in cash dividends to its shareholders last year and its price is trading at $50 today, then it has a dividend yield of 10%, historically high, meaning the P/E ratio is low indicating undervalued stocks.

Historically, at severely high P/E ratios (such as over 100x), a stock has NO dividend yield (0.0%). Because with a P/E ratio over 100x, it would take over a century to earn back the purchase price. Such stocks are extremely overvalued, so you would have no quarterly cash dividend.

The Averages

The average U.S. equity P/E ratio is 14, meaning it takes about 14 years for a company you purchase to earn back your full purchase price for you.

A P/E ratio of 14 corresponds to an average annual return of 7% (1/14th).

An example

An easy and perhaps intuitive way to understand the concept is with an analogy:

Let's say, I offer you a privilege to collect a dollar every year from me forever. How much are you willing to pay for that privilege now? Let's say, you are only willing to pay me 50 cents, because you may think that paying for that privilege coming from me could be risky. On the other hand, suppose that the offer came from Bill Gates, how much would you be willing to pay him? Perhaps, your answer would be at least more than 50 cents, let's say, $20. Well, the price earnings ratio or sometimes known as earnings multiple is nothing more than the number of dollars the market is willing to pay for a privilege to be able to earn a dollar forever in perpetuity. Bill Gates's PE ratio is 20 and my PE ratio is 0.5.
Now view it this way: The PE ratio also tells you how long it will take before you can recover your investment (ignoring of course the time value of money). Had you invested in Bill Gates, it would have taken you at least 20 years, while investing in me could have taken you less than a year, i.e. only 6 months.

If a stock has a relatively high PE ratio, let's say, 100 (which Google exceeded during the summer of 2005), what does this tell you? The answer is that it depends. A few reasons a stock might have a high PE ratio are:

  • The market expects the earnings to rise rapidly in the future. For example a gold mining company which has just begun to mine may not have made any money yet but next quarter it will most likely find the gold and make a lot of money. The same applies to pharmaceutical companies — often a large amount of their revenue comes from their best few patented products, so when a promising new product is approved, investors may buy up the stock.
  • The company was previously making a lot of money, but in the last year or quarter it had a special one time expense (called a "charge"), which lowered the earnings significantly. Stockholders, understanding (possibly incorrectly) that this was a one time issue, will still buy stock at the same price as before, and only sell at at least that same price.
  • Hype for the stock has caused people to buy the stock for a higher price than they normally would. This is called a bubble. One of the most important uses for the PE metric is to decide whether a stock is undergoing a bubble or an anti-bubble by comparing its PE to other similar companies. Historically, bubbles have been followed by crashes. As such, prudent investors try to stay out of them.
  • The company has some sort of business advantage which seems to ensure that it will continue making money for a long time with very little risk. Thus investors are willing to buy the stock even at a high price for the peace of mind that they will not lose their money.
  • A large amount of money has been inserted into the stock market, out of proportion with the growth of companies across the same time period. Since there are only a limited amount of stocks to buy, supply and demand dictate that the prices of stocks must go up. This factor can make comparing PE ratios over time difficult.
    • Likewise, a specific stock may have a temporarily high price when, for whatever reason, there has been high demand for it. This demand may have nothing to do with the company itself, but may rather relate to, for example, an institutional investor trying to diversify out risk.

Inputs

In practice, decisions must be made as to exactly how to specify the inputs used in the calculations. Does the current market price accurately value the organization? How is income to be calculated and for what periods? How do we calculate total capitalization? Can these values be trusted? What are the revenue and earnings growth prospects over the time frame one is investing in? Was there special one time charges which artificially lowered (or artificially raised) the earnings used in the calculation, and did those charges cause a drop in stock price or were they ignored? Were these charges truly one-time, or is the company trying to manipulate us into thinking so? What kind of PE ratios is the market giving to similar companies, and also the PE ratio of the entire market?

A distinction has to be made between the fundamental (or intrinsic) PE and the way we actually compute PEs. The fundamental or intrinsic PE examines earnings forecasts. That is what was done in the analogy above. In reality, we actually compute PEs using the latest 12 month corporate earnings. Using past earnings introduces a temporal mismatch, but it is felt that having this mismatch is better than using future earnings, since future earnings estimates are notoriously inaccurate and susceptible to deliberate manipulation.

The PE concept in business culture

The PE ratio of a company is a gigantic focus for management in many companies and industries. This is because management is primarily paid by their companies stock (which is supposed to align their interest with other stock holders), and to make the stock price go up one either must improve earnings or improve the multiple the market assigns to those earnings. As mentioned earlier, one of the main explanations of why a company has a higher PE ratio is because the company has a sort of sustainable advantage that allows it to grow earnings over time (ie, investors are paying for their peace of mind). Efforts by management to convince investors that their companies are like this have had profound effects on business:

  • The primary motivation for building conglomerates is to diversify earnings so that they go up steadily over time.
  • The choice of businesses which are enhanced or closed down or sold within these conglomerates is often made based on their percieved volatility, regardless of the absolute level of profits or profit margins.
  • One of the main genres of financial fraud, "slush fund accounting" (hiding excess earnings in good years to cover for losses in lean years), is designed to create the image that the company always slowly but steadily increases profits, with the goal to increase the PE ratio.

These and many other actions used by companies to structure themselves to be perceived as commanding a higher PE ratio can seem counterintuitive to some, because while they may decrease the absolute level of profits they are designed to increase the stock price.

The PE is calculated primarily for common shares, not for preferred shares. The appropriate calculation for preferreds is the preferred dividend coverage ratio.

A related concept is the "PEG ratio". This is the PE ratio adjusted by a growth coefficient. It is sometimes used in high growth industries and new ventures. Its use is controversial.

Another practice, which is not mainstream, based on behavioral finance, is to take market behavior parameters, among which the stock image, as factors playing a part in the level and evolution of the PE.

The PE can be applied not only to shares, but to other assets also. Thus the PE, comparing Price to Rental Incoming for housing is an important measure in the analysis of the existence or not of Property_bubbles.

See also


Lists

Data

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