Explaining Price Earning Ratio
Price Earning Ratio (commonly referred to as P/E ratio) defines the ratio that the company’s share price is when looking at per-share earnings. Just as the name implies, in order to calculate this ratio, we divide the Market Value per share to EPS (Earnings per Share).
In most situations the price earning ratio is calculated by using EPS from the past 1 year. Occasionally, this EPS uses figures that estimate the earnings over the following 4 quarters as the EPS is estimated. In this case, we are talking about a projected or leading price earning ratio. The third option that is available uses EPS from the past 2 quarters together with estimates of the following 2 quarters.
The difference between the variations is not at all huge but we have to understand the fact that actual historical data is used with the first of the calculations mentioned. The other 2 are just based on what we expect so we do not have something that is precise or perfect. Those companies that have negative EPS bring in problems in calculating P/E. If we calculate historically, average P/E ratio calculated in the market is of around 15 to 25. Based on economic conditions, this can fluctuate significantly.
How P/E Is Used
In theory, the stock’s Price Earning Ratio highlights the amount that the investor is willing to pay when looking at earnings dollars. That is why we sometimes see it referred to as a stock multiple. So, if we see a P/E of 15, the investors will most likely want to invest around $15 for every single $1 of earnings that the firm generates. The only problem is that this is quite a simple calculation and does not consider growth prospects.
EPS can be used for the last 1 year so we can say that P/E stands out as the measure of the performance that a company had in the past. Stock prices will reflect what the investor thinks a company is worth. The future growth is always taken into account when looking at the stock price so interpreting P/E ratio is better when looking at market optimism based on growth prospects.
When a company has high price earning ratio, higher than industry average, the market expects a lot of great things over the following months or years. If the ratio is high, the company will usually end up with higher rating thanks to increasing earnings. As a simple example, many years ago, Microsoft had a P/E of over 100 and we all know how great the firm ended up evolving.
Expensive Or Cheap
P/E is a very good ratio that you can use when compared with market price. If we have P/E of 75 and a stock of $10, we are faced with something that is more expensive when referring to a stock that is $100 and P/E of 15. Limits do exist with this analysis. For instance, we cannot compare price earning ratio of 2 countries in order to determine the better value. We have to consider the following in order to see if P/E is low or high:
- Company Growth Rates – this shows us how fast the company grew in the past and whether or not rates will be expected to continue, increase or drop.
- Industry – we can only compare companies in the event that they are in exactly the same industry. As a very simple example, the utilities do have really low multiples as low growth appears in a relatively stable industry. Technology industry does have great growth rates but also a constant change. We cannot compare tech firms with utility firms because of this.