The P/E Ratio: What Does It Mean?
The price-earnings ratio (P/E ratio) is a common metric used to assess the value of a company by comparing its current share price to its per-share earnings (EPS).
Price multiples and earnings multiples are other names for the price-to-earnings ratio. Investors and analysts use P/E ratios to make a fair comparison of two different companies’ share prices.
It can also be used to compare an organization to its past performance or to analyze the performance of multiple marketplaces at once or over time.
P/E can be calculated using either historical data (trailing) or forecasted figures (forward-looking).
KEY POINTS
- The P/E ratio compares the current share price of a firm to its per-share earnings.
- Stocks with a high price-to-earnings ratio could be overvalued, or investors can be anticipating rapid future earnings growth.
- Businesses that are in the red or have never turned a profit do not have a P/E ratio since the denominator cannot be calculated without earnings.
- In practice, forward P/E and trailing P/E ratios are utilized.
- An analyst will place the most weight on a P/E ratio when comparing it to other firms in the same industry, or to the P/E ratio of the same company over time.
P/E Ratio: Formula And How to Calculate It
The following is the calculation and formula utilized in this operation.
The P/E ratio is calculated by dividing the stock price by earnings per share (EPS).
Although the current stock price (P) is easily accessible by entering a stock’s ticker symbol into any finance website, reflecting the actual cost to investors at the moment, the earnings per share (EPS) is more of a conceptual number.
There are primarily two types of EPS. “trailing 12 months” is abbreviated as “TTM” on Wall Street. This figure represents the company’s progress during the past calendar year.
The second form of EPS can be seen in the results report of a corporation and typically takes the form of EPS guidance.
This represents the company’s most educated estimate of its future profit. Trailing P/E and forward P/E are calculated using these two variations of EPS.
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Calculating Your P/E Ratio
Investors and analysts frequently use the price-to-earnings ratio (P/E) as a proxy for the stock’s value. You can tell if a stock is overpriced or underpriced by looking at its P/E ratio.
The price-to-earnings (P/E) ratio of a firm can be compared to that of other companies in the same industry as well as to the price-to-earnings (P/E) ratio of the S&P 500 Index and the overall market.
The P/E 10 and P/E 30 measures, which average earnings over the past 10 and 30 years, are sometimes considered by analysts who are interested in long-term value patterns.
Because of their ability to smooth out short-term fluctuations in the economy, these indicators are frequently employed when attempting to assess the general worth of a stock index like the S&P 500.
From its low of roughly 5x (in 1917) to its high of over 120x today, the S&P 500 P/E ratio has seen a wide range of values (in 2009 right before the financial crisis).
Stocks in the S&P 500 typically trade at a premium of about 16 times trailing 12-month earnings, according to the index’s long-term average P/E of roughly 16x.
Example of the P/E Ratio
Let’s use the $139.55 closing price of Walmart Inc. (WMT) stock on February 3, 2021, as an example P/E ratio calculation.
According to The Wall Street Journal, the company’s EPS for the fiscal year ended January 31, 2021, was $4.75.
Thus, the price-to-earnings (P/E) ratio for Walmart was:
$139.55 / $4.75 = 29.38
Absolute Price-to-Earning
In addition, analysts may differentiate between absolute P/E ratios and relative P/E ratios.
Absolute P/E Ratio
This ratio is calculated by dividing the current stock price by either the trailing earnings per share (TTM), the expected earnings per share for the future 12 months (forward P/E), or some combination of the two.
When comparing absolute P/E to relative P/E, keep in mind that absolute P/E indicates the P/E in effect during the current time period. If the current stock price is $100 and the TTM EPS is $2, the P/E ratio is 50 ($100 divided by $2).
Relative P/E Ratio
For calculating relative P/E, the present absolute P/E is measured against a benchmark or a range of historical P/Es over a relevant time period, such as the past 10 years.
How high the present P/E is in comparison to historical P/Es is indicated by the relative P/E. While most uses of relative P/E compare the current P/E to the highest P/E in the range, investors may also use the metric to see how close the current P/E is to the lows in the range.
If the present P/E is lower than the historical P/E, the relative P/E will be less than 100%. (whether the past high or low). If the current P/E ratio equals or exceeds the historical average, the stock’s price will rise.
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Importance of P/E Ratio
The price-to-earnings (P/E) ratio is a useful tool for valuing a company’s shares according to its profitability.
The ratio indicates the price at which investors are willing to purchase a portion of a company’s future growth and existing operations.
A high P/E ratio indicates that the market is willing to splurge in light of the company’s expected future profits.
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