Price Earnings Ratio (P/E)

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Definition of Price Earnings Ratio (P/E):

The Price Earnings Ratio (more commonly referred to as the P/E) is used by investors to measure the relative value of a stock. It is the amount paid per dollar of earnings.

Detailed Explanation:

Assume you are an investor. Would you want to own stock in a company that consistently earns a profit? Would that be more important to you than how much you might like the good or service? Most investors do not invest in a company because the senior manager is a nice guy or because the product looks nice. They invest only if they believe the company will earn a profit in the future, even if the company is presently generating losses because, future expectations of earnings drive a stock’s price. The challenge is choosing undervalued companies that will exceed earnings expectations. The P/E ratio measures how much an investor is paying for profits. The P/E ratio equals the price per share divided by the earnings per share. 

P/E ratio = Price per share / Earnings per Share

For example, if a company earned $3.00 per share and a share of the company’s stock sells for $30, the investor is paying $10 per dollar of earnings. The company’s P/E ratio equals 10.
 
Investors use the P/E ratio to evaluate the relative value of stocks. Many prominent investors use it to identify companies that are undervalued. Assume you are considering purchasing stock in two competing companies that are similar in every way. ABC’s shares are selling for $50. Recently ABC earned $2 per share.  XYZ’s share price equals $25, and the company earned $0.75 per share recently. Which stock would you purchase? You would pay less per dollar earned if you purchased ABC. ABC’s P/E ratio equals 25. XYZ’s P/E ratio equals 33.33. You would pay $25 for every dollar earned if you purchase ABC, and $33.33 per dollar earned if you purchase XYZ. ABC is relatively less expensive. 

Investors are purchasing a future stream of income, so let’s use the same example but you believe the earnings of ABC will increase to $2.50 per share and XYZ’s earnings will grow to $1.50 per share. Which would you purchase? Most investors will choose XYZ because its growth in income results in a lower P/E ratio. Today’s P/E ratios using expected future earnings would equal 20 and 16.67 for ABC and XYZ, respectively. 

P/E ratios are useful when considering similar companies but should not be used to compare two companies in different industries. For example, the average P/E ratio in the automotive industry may be 8, but the technology companies may be 40. The wrong conclusion would be reached if the industries were not taken into consideration. For example, an investor may conclude an automotive company (TFS) with a price earnings ratio of 12 is undervalued compared to a tech company (LIN) with a ratio of 30. However, this is wrong because relative to other automobile companies, TFS is overvalued. LIN is undervalued when comparing it to other companies in its industry. Growth companies normally have a higher price earnings ratio than mature companies because their expected growth in earnings is higher. 

The P/E ratio can be used to project the price of a share. For example, assume you want to take advantage of a dip in the stock market. You are looking at a company that sells for $100 per share. Its P/E ratio is 50, but its average P/E ratio for the past five years has been 60. Analysts project earnings to double in the next two years. You believe the P/E ratio will return to 60. What is your projected price? The company must have earned $2.00 per share if the current P/E ratio equals 50, and the stock is selling for $100 per share. Analysts predict profits will double to $4.00 per share in two years. You expect the P/E ratio will increase to 60, so your anticipated price per share would equal $240! Of course, you have made many assumptions in reaching your projected price and any error in your judgment changes the final price. 

Investors need to determine the reason for a sudden change in the P/E ratio before choosing to buy or sell a stock. For example, is a sudden jump in a company’s P/E ratio the result of an appreciating stock? This is good assuming there will be an increase in the company’s income that is sustainable? If it isn’t, the high P/E ratio may suggest it is time to sell and cash in on the stock’s appreciation. It is a bad sign if the increase in the P/E ratio resulted from a drop in the company’s earnings. Conversely, an investor may consider purchasing a stock that appears undervalued following a drop in the stock’s P/E ratio. However, this is likely a poor decision if the share price dropped following an event that reduced the probability of earning a profit. The P/E ratio is a great tool for measuring a stock's relative value, but investors should interpret any change in the ratio before or after investing. 

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