The price-to-earnings (PE) ratio is an important financial metric used to identify the amount that investors or shareholders are willing to pay for a company. It simply compares the current share price and a company’s earnings.
In this article, we’ll look at what the PE ratio is, how it is calculated, its types, and how to use it in the market.
What is the PE ratio?
The PE ratio is a financial calculation that weighs a company’s earnings and the share price. Earnings refers to a company’s earnings per share, also known as EPS while the price is the current share price of the company.
The PE ratio is an important number that is mostly used by long-term investors who want to see whether a company is overvalued and undervalued. A company with a PE ratio of 10 is said to be undervalued compared to one whose PE ratio is at 40.
However, as we will explain below, this does not always mean that a firm with a lower PE is better than the one with a higher multiple. In fact, in most times, firms with higher multiples perform better than the others.
How Price-to-Earnings is calculated
The calculation of PE ratio is relatively easy. You use the following formula:
|PE Ratio = Market value per share / Earnings per share|
The market value per share refers to the current share price. For example, in February 2021, Apple’s share price is trading at $136, making it the market value per share.
The earnings per share (EPS) is usually provided in a company’s income statement. It is simply calculated by taking a company’s net earnings and dividing it by the outstanding shares.
For example, if a company made a net profit of about $1,000,000 and it has 10,000 shares, it means that the earnings per share is 100.
There are several types of EPS in the market, including:
- diluted EPS
- ongoing EPS
- forward EPS
- headline EPS
Also, the PE can be based on General Accepted Accounting Principles (GAAP) and non-GAAP basis.
As a trader, you can find the PE ratio of a company by just calculating. However, you can find it in most of the free charting and financial media platforms like Investing.com and SeekingAlpha.
For example, the image below shows the PEs of companies like Apple and Dell.
Types of PE ratio
As seen above, there are several types of PE ratio that are important for investors and traders. First, there is a trailing PE ratio. This simply means the ratio of the current price and the past earnings.
For example, you can use a company’s trailing twelve-month earnings to calculate the ratio.
Second, there is the forward PE ratio. This is where you use the current price of a stock and the average analysts’ forecasts. You can get the average earnings forecasts from companies like SeekingAlpha, Finviz, Investing, and Yahoo Finance.
While the trailing PE is useful, many investors prefer using the forward ratio because of their forward-looking characteristics. In other words, investors are more concerned about the future than the past.
Third, there is the GAAP and non-GAAP PE ratio. The two use the current share price and the GAAP and non-GAAP earnings. As shown above, the two ratios are usually different for the same company.
Fourth, there is the PEG ratio, which simply means the price-to-earnings to-growth ratio. Basically, this is a type of PE ratio that also factors-in a company’s growth. It is calculated by dividing the share price and EPS and then dividing the result by EPS growth.
Common Alternatives to PE ratio
There are several other popular alternatives to the PE ratio of a company. The most popular is known as the price to sales (PS) ratio. It simply measures the company’s revenue in a certain period to the share price.
While this is a good ratio, it tends to say little about a company because investors are more concerned about a firm’s profitability.
Second, there is the enterprise value (EV) to Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) ratio. This is a useful ratio that compares a firm’s enterprise value and its EBITDA.
The EV shows the real value of a company by considering the market cap, equity, and debt.
Third, there is the price to cash flow ratio that measures the current price and compares it with the current free cash flow (FCF).
How to use the PE ratio in trading
In most cases, the PE ratio of a company is not used by day traders. That’s because traders are only focused on a company’s share price movement and not the intrinsic value. In their part, investors use the PE ratio in several ways.
For example, they compare a company’s PE ratio with the overall PE ratio. For example, you can compare a company’s ratio with that of its peer companies or the overall S&P 500 index.
A good source of the S&P 500 PE ratio is Multipl. If the S&P 500 PE ratio is 30 and a company has a ratio of 10, it means that the company is undervalued. Investors also compare a firm’s PE ratio with that of its peer firms.
A common mistake many investors do is to always invest in low multiple companies. In the past, many high PE stocks like Shopify and Crowdstrike tends to outperform those with lower PEs.
That’s because the demand for high-flying tech companies is usually higher than that of companies in traditional sectors like oil and gas.
The PE ratio is a term you will always encounter in your trading and investing journey. In this article, we have looked at what it is, how to calculate it, the several types of PE, and other terms related to the PE.
External Useful Resources
- Stock Analysis Using the P/E Ratio – Schwab