From Traderpedia

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:

<math>PE~ratio = \frac{share~price}{earnings~per~share}</math>

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.

[edit] 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.
• 14-20 - Fair value, normal.
• 21-28 - Overvalued.
• 28+ - Stock market is in a speculative bubble.

[edit] 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% (1/14ths).

[edit] 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, 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 company was previously making a lot of money, but in the last year 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.
• 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, 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 making comparing PE ratios over time difficult.

[edit] 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? 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.

Back to Fundamental Analysis