What Is P/E Ratio? Formula, Types, Uses, And Limitations Explained

What is P/E ratio?

The price-to-earnings ratio, as its name suggests, compares a company’s stock price to its earnings per share (EPS). If we talk in terms of dollars, the P/E ratio indicates the dollar amount you must invest in a business to get $1 of its earnings.

The next question you might ask is, is a high or low P/E ratio better?

Well, a high P/E ratio simply means a stock is expensive in relation to what it earns while a low P/E ratio means the stock is less expensive in comparison to its earnings.

One must remember that a company’s P/E ratio never stays the same as stock prices are constantly fluctuating.

Why is the P/E ratio important?

When investing in a company, you need to know how much profit the business makes at present and how much profit it will generate in the future. This is where the P/E ratio comes in. Unlike the stock price, which simply tells you how much you must pay to own a share in the company, the P/E ratio determines the earnings potential of a stock and, therefore, its value over some time.

However, looking at a company’s P/E ratio at just one given time is insufficient to determine its true value. A deeper understanding requires comparing the company’s current P/E ratio with its past P/E ratios over a long period or against the P/E ratios of rival companies in the same industry. The P/E ratio is, therefore, a tool that helps you determine the value of a company by studying its earnings record or by comparing it with one or more companies in the same industry.

P/E ratio formula explanation

The formula to calculate the P/E ratio is quite straightforward:

P/E = Stock price per share / Earnings per share.

However, the formula can lead to two different results because there are different ways to calculate the earnings per share (EPS).

Types of P/E ratio

Depending on the method used to calculate the EPS, there are two variants of the P/E ratio – the trailing P/E ratio and the forward P/E ratio.

• Trailing P/E ratio: Also called Trailing Twelve Months (TMT) Earnings, the trailing P/E ratio is calculated using company earnings over the past 12 months. This method of calculating the P/E ratio is widely used because it uses current, up-to-date data to measure the company’s financial performance. Trailing Twelve Months can mean 12 months before the current month or 12 months preceding the company’s most recent earnings report.
• Forward P/E ratio: This is calculated using projections of future earnings. Unlike the trailing P/E ratio, it does not have the benefit of using actual reported data. However, the forward P/E ratio is still a widely used metric as it uses the best available information to predict a company’s earnings for a specific period in the future without accounting for any changes or adjustments from the current period. The forward P/E ratio is also called leading P/E or estimated P/E ratio.

Example: P/E ratio calculation

Stock price per share: SGD 50

Earnings per share: SGD 5

P/E ratio = 10

How do you analyse the P/E ratio?

The P/E ratio is a piece of data. It is only useful if you make a correct analysis of this data to make an informed investment choice. When presented with the P/E ratios of companies you are considering investing in, ask yourself the following questions:

What does a high P/E ratio mean?

A high P/E ratio could mean two things – that a stock is overvalued, or that investors are willing to pay a high price for it as they expect it to get them high returns in the future. Due to the second interpretation, a stock with a high P/E ratio is also called a growth stock or growth investment. The promise of higher returns makes stocks with a high P/E ratio attractive to investors. However, the downside is that growth stocks are usually considered more volatile and, therefore, more risky than stocks with low P/E ratios.

What does a low P/E ratio mean?

A low P/E ratio is usually considered a great bargain, which is why such stocks are called value stocks. Most people prefer value stocks over growth stocks because you spend less for every dollar earned. However, a low P/E ratio should not be your only consideration when investing. It is important to do a little more research. A loss-making company, for instance, might have a low P/E ratio.

What does a negative P/E ratio mean?

Apart from a high or low P/E ratio, there is also a negative P/E ratio. Companies that have zero earnings or are losing money have a negative P/E ratio. While a negative P/E ratio sounds undesirable, it is not necessarily a bad investment. Most companies – even high-performing businesses – go through brief periods of uncertainty and volatility that affect their earnings. As a potential investor, you must make inquiries to find out if a company is persistently in the red or if it is just going through a rough patch and still holds the potential of being a big earner in the future. Growing companies with little accumulated earnings or businesses with high expenses on account of a major project in the pipeline (a pharmaceutical firm in the process of creating a new drug, for example) might have negative P/E ratios.

What is a good P/E ratio for different industries?

This is a subjective question to which there is no definite answer. However, most industries or sectors have an average P/E ratio that can be used as a benchmark. The average differs from sector to sector. Technology firms are associated with higher P/E ratios, signaling higher growth prospects. Companies in the utility business (electricity, water, gas, etc) have comparatively lower P/E ratios. But even within an industry, there can be anomalies. Take Amazon, for example, which is known for having a much higher P/E ratio than its rivals in the retail space. This might be because of its high growth potential or due to a reduction in earnings caused by expansion and reinvestment expenses. The prospect of high earnings makes Amazon a favoured stock despite its high P/E ratio.

Is a high or low P/E ratio better? A comparison

HIGH P/E RATIO

• Stock price is higher than the average stock price in the industry 
• This could mean that investors have high growth/earnings expectations from the stock
• Or, it could mean that the stock is overvalued (overpriced in relation to its earnings) 

LOW P/E RATIO

• Stock price is lower than the average stock price in the industry 
• This could mean that investors have low expectations of growth or earnings from the stoc
• Or, it could mean that the stock is undervalued (underpriced in relation to its earnings)

Example: P/E ratio as a tool to assess company valuation and investor sentiment 

(Insert table here)

On the face of it, Stock X is more expensive than Stock Y. However, a comparison of their P/E ratios reveals that Stock X is the cheaper of the two because the investor pays less for each dollar earned. Another interpretation would be that Stock Y has a higher P/E ratio than its rival due to higher expectations of growth. In this way, the P/E ratio is a useful tool to determine a company’s value by comparing it with another or to gauge what investors expect of a particular company and its stocks.

P/E ratio vs Earnings yield

Earnings yield is the opposite of the P/E ratio. If the P/E ratio is stock price per share divided by earnings per share, then earnings yield is earnings per share divided by stock price per share. Earnings yield shows earnings as a percentage of stock price and is, therefore, expressed in percentage. Earnings yield is mostly used to compare stocks with bonds, certificates of deposit, and other such assets.

P/E ratio vs PEG ratio

Closely related to the P/E ratio is the price/earnings-to-growth ratio or PEG ratio. The PEG ratio helps you determine whether a stock is overvalued or undervalued by analysing both its current price and its projected growth rate for a specific period in the future. The formula is PEG ratio = trailing P/E ratio / projected growth rate. The PEG ratio gives you a better valuation of a stock or company than the P/E ratio. While it does give a clearer picture than the P/E ratio, it must be noted that the PEG ratio also works on projected growth estimates, which might fall short in reality.

Absolute P/E vs relative P/E

A P/E ratio that is calculated using either the trailing or forward methods is called absolute P/E. On the other hand, relative P/E is the result of a comparison between the current absolute P/E and past P/Es over a specific period (five years, 10 years, etc). The relative P/E compares the absolute P/E to either the highest value or the lowest value during that period.

For example, if a company’s current (absolute) P/E ratio is 30 and its highest P/E ratio in the last 10 years is 50, then the relative P/E is 0.6 (30 / 50). This means the company’s current P/E is 60% of its 10-year high. Similarly, if the company’s lowest P/E ratio during the same 10-year period is 20, then the relative P/E in this case is 1.50 (30 / 20). This means the current P/E is 50% higher than the 10-year low.

Limitations of the P/E ratio

As useful as the P/E ratio is, it isn’t wise to rely solely on it to make investment decisions. The P/E ratio has the following limitations, which one must take into consideration:

Comparison of companies across sectors isn’t possible

The P/E ratio can only be used to compare companies from the same industry. So, you may use it to compare one financial services company to another but not a financial services company to a retail business.

2. Negative earnings pose a challenge

You cannot use the P/E ratio to compare companies with negative or zero earnings. As a result, investors might miss out on companies with great growth prospects simply because they are showing no earnings currently. The negative earnings might be due to the company pumping all its resources into growing the business, which would show results in the future.

3. Earnings data isn’t foolproof

A major shortcoming of the P/E ratio is that it relies on earnings data, and earnings might not give the full picture of a company’s long-term profitability. Earnings can be affected by events such as the sale of assets or the taking of a loan. So, a company with a seemingly attractive low P/E ratio might have a large debt to pay off while a company with a less desirable high P/E ratio might be debt-free and in good financial health. Earnings data might also differ if companies use different accounting practices to arrive at their figures. Furthermore, companies can manipulate their earnings data to lower their P/E ratio and make their stock more attractive to investors.

4. Market volatility poses a risk

The P/E ratio is dependent on stock prices, which can go up or down when the stock market experiences volatility. This volatility is caused by external factors such as political events (regime change, elections, etc), economic events (inflation, GDP calculations, change in bank policies, etc), global events (war, terrorism, etc), natural disasters, changes in investor sentiments, and so on. Market volatility is a common occurrence and it is wise to guard against it when making investment decisions.

The limitations of the P/E ratio show that it cannot be your only consideration when buying stocks. However, it remains a significantly reliable metric and can greatly benefit your decision-making if paired with thorough market research.

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