The price-to-earnings (P/E) ratio is an evaluation ratio that relates a company's existing share price and its earnings per share (EPS). The P/E ratio is sometimes known as the price multiple or earnings multiple.
Investors and financial analysts utilize P/E ratios to assess the comparative value of the shares of a company in an apples-to-apples relation. You can also use a P/E ratio to relate a company to its own track record, as well as to relate collective markets to each other or over time.
P/E can be calculated in two ways: trailing P/E and forward P/E.
P/E Ratio Formula
The formula for calculation of the P/E ratio are as follows,
How to Calculate P/E Ratio?
To compute the P/E ratio value, you must divide the recent market price by EPS. You can calculate the current market value by plugging a stock ticker symbol in any financial website. However, this substantial value represents what investors should pay for an equity or stock, and the EPS is slightly vague.
There are two kinds of EPS. TTM or "trailing 12 months" is a Wall Street acronym. This figure signifies the performance of the company over the last 12 months. The second EPS type can be found in an earnings release, which usually involves EPS guidance. This is the best-educated guess of what the company expects to earn in the long term. These various EPS versions are the basis for forward and trailing P/E ratios.
P/E Ratio Example
Here's an example: A company's profits are consistent from quarter to quarter, as well as its projected profits are also stable.
If its stock price rises but its earnings remain unchanged (and no significant increase in revenues is expected), the company's intrinsic value remains intact; only the market's image of the company has changed.
In this case, the revenues in the PE ratio remained constant while the price increased, raising the overall PE ratio. The stock may be overvalued if a company's PE ratio is considerably higher than its contemporaries.
Variants of the P/E Ratio
Although the formula for calculating the P/E ratio, which is just the price divided by the profits, is simple, several ways to adjust the pricing or earnings are utilized.
The P/E ratio is most frequently calculated using the stock's current price, while it is also possible to use the stock's average price over a specified period. But there are three different ways to calculate the P/E ratio regarding the income component, and each tells you something different about a stock.
Forward Price-to-earnings (P/E)
Instead of trailing numbers, the forward P/E uses future earnings predictions. This forward-looking measure, also known as "estimated P/E," helps compare current revenues to projected earnings and presents a more accurate image of what earnings would look like—without modifications and other accounting modifications.
However, the forward P/E variant has built-in issues, such as the possibility that companies could overestimate earnings to beat the estimated P/E when the following quarter's earnings are revealed. Other companies might exceed the estimated ratio and then decrease it before making their subsequent revenue report. Moreover, estimates from outside experts may differ from those made by the company, which can be confusing.
Trailing Price-to-Earnings (P/E)
The Trailing P/E refers to a company's past performance that you can calculate by dividing the current market share price by the total EPS income over the last 12 months. Trailing P/E is the most widely used P/E metric because it provides the company with honestly reported earnings. Some investors look at the trailing P/E because they need to trust other people's earnings projections. However, the trailing P/E also has some drawbacks, particularly since a company's previous performance doesn't predict its future behavior.
Since earnings are only revealed once a quarter while stocks are traded continuously, the trailing P/E ratio will change along with the price of a company's stock. Some investors, therefore, prefer the future P/E.
What is a good P/E Ratio?
The answer to this question will always rely on the sector in which the company operates. Since the P/E ratio is a comparison tool and not a benchmark value, no "good" PE ratio exists. The average P/E ratio will vary by industry, with some having larger ratios than others. For instance, in January 2021, the average trailing P/E ratio for publicly traded television firms was only about 12, whereas it was over 60 for software companies.
Comparing a P/E ratio to the average P/E of its competitors in the same industry might help you determine whether it is high or low in general.
Limitations of the P/E Ratio
The P/E ratio has some limitations that investors should be aware of, just like any other fundamental designed to help investors decide whether or not a stock is worth buying.
- The P/E ratio can significantly impact EPS measurements, such as forward or trailing EPS, that exclude one-time events.
- Additionally, EPS is a glimpse at a specific moment and might not accurately represent average earnings.
- A company may not reach its EPS estimates, which affects the accuracy of forward P/E ratios, and EPS needs to reflect a company's financing structure sufficiently. Therefore, a P/E ratio cannot be calculated for a loss-making company. Because of interest payments, a corporation with greater debt could have lower EPS. However, debt may increase future earnings growth if the money is put into the company.