Anyone who’s been in the investment market long enough will be aware of the many valuation tools that are used. Each one considers different valuation parameters and has its merits and demerits, but none of them are used on its own. Only the best professional analysts know the right combination to arrive at realistic valuation figures. PE ratio or price to earnings ratio is one such popular valuation tool.
PE Ratio or Price to Earnings Ratio
The most common method of company valuation is the market cap. Among investors and analyst circles, conversations about market cap are pretty common. It is simply the total value of outstanding stocks in the market, but this is only an overview. Even while considering a company’s stock price, there could be many factors that might swing investment decisions despite a company displaying a high market cap. This is precisely the importance of the PE ratio.
What is PE Ratio?
Price to earnings ratio, otherwise also known as the ‘earnings multiple’ or the ‘price multiple’ is a valuation ratio that helps determine the relative valuation of company stock. It considers the current stock price and compares it to the company’s earnings per share (EPS). The earnings per share are actually the company’s estimated earnings on every share. This is either reinvested back into the company or distributed among the shareholders as dividends. EPS is a direct indication of the company’s stock performance in the market.
Price to earnings ratio has a direct correlation with the stock price. The higher the stock price, the higher the PE ratio. Investors estimate a company with a high PE ratio is expensive, and the stock price might eventually fall. The ones with a lower PE ratio indicate low stock price, which will rise as the business expands. However, this stand-alone correlation is not enough. Analysts must look deeper into the historical data of PE ratios of a company to understand the trends.
Why is P/E Ratio important?
There are many company valuation methods. Based on the nature of investments and the industry being catered to, analysts use multiple methods to arrive at a practical valuation of a company compared to the others in the same sector. But very few offer the benefits of the PE ratio. The three factors that enhance the importance of PE ratio are:
- Fair comparison – Since the price to earnings ratio compares stock-related data of a company and studies trends in equity fluctuations over time, the benchmarks are internal. There is no need to rely on any information from the industry or market to use this valuation ratio.
- Long-term valuation – Leading with the fact that the PE ratio allows a fair comparison, it is also important to note that it enables an archival comparison of a company’s performance. For example, ratios like P/E 10 helps to average the past 10 years of earnings. Similarly, ratios like P/E 30 averages the past 30 years of earnings. All the data required to make these calculations are readily available in the company’s financial records.
- Overall value of stock index – Probably the most important application of PE ratio by industry is that it helps analyze the overall value of the stock index, for eg, in the case of the S&P 500. It is normal for a business to undergo fluctuations over time. But by using this ratio, investors can nullify the effect of fluctuations on the market as well as the business cycle and arrive at a realistic valuation of comparable companies within the same industry.
Types of P/E Ratio
P/E ratio as a value is still a relative comparison between the current stock price and the EPS. But based on the timeline of stock price consideration, they are categorized into the following:
Forward P/E Ratio
This price to earnings ratio compares current earnings to future earnings. It is otherwise also known as ‘estimated price to earnings‘. It gives a futuristic estimate of what the future earnings might look like. In this case, ‘future’ per se refers to the EPS projections for the next four quarters. It helps investors to look beyond historical data and base their investment decisions on the future potential of a company. However, this ratio does run the risk of either an overestimate or an underestimate as it depends on future projections. It is not an easy value to calculate and must be left in the hands of experts.
Trailing twelve months P/E Ratio
This ratio on the contrary, as the name suggests, uses EPS data from the past 12 months. As a metric, investors prefer to use this ratio as it is based on reliable data. Investors can judge a business’s current performance caliber based on how it has been performing over the past 1 year. However, sometimes, this could be misleading as well. Let’s say a business has new expansion plans in the pipeline, or have planned something else for the business. These certainly do not reflect on their past performance but can catapult the company to greater heights.
Absolute P/E Ratio
This ratio uses the current stock price but either uses EPS of the last 12 months or a combination of two quarters of forward EPS and two-quarters of TTM. The uniqueness of the absolute price to earnings ratio lies in the fact that it accounts for all data in the present. It does not lean whole on either the past or the future projections.
Relative P/E Ratio
On the other hand, this ratio embodies relative comparisons. It accounts for the absolute P/E (which is based on current data) and compares it to P/E values of the past. This time frame will depend on the time period set by investors. It could be 10 years or 20 or even 30. Another direct approach could be to compare the absolute P/E with the highest P/E value of the assumed time frame.
P/E Ratio Formula
As discussed as far, the PE ratio formula is as follows:
- Current stock price = current price of a stock in the market
- Earnings per share = profit made by company per share (forward or TTM)
P/E Ratio Limitations
As mentioned earlier, there are many valuation ratios used by investors. Each has its advantages and drawbacks, and none of them are absolute. Similarly, the PE ratio has its limitations too. Some of the disadvantages of price to earnings ratio are:
- A company might not have profitable earnings to show at the calculation time. This could be misleading as they might pick up soon with the right investment. PE ratio, in this case, might render the entire business unfit for investment.
- The PE ratio formula is suitable to compare companies within the same industry. Even then, the way businesses make money may differ from one to another. This might lead to skewed comparisons.
- While using the forward price to earnings ratio, assumptions about future projections could be a limitation if not estimated correctly.
P/E Ratio By Industry
Based on our understanding so far about the importance of the PE ratio, here is a compilation of values as per industry. As is seen, the range of value varies from one industry to another. Thus investors must use the right values to arrive at profitable investment decisions.
|Row Labels||Annual Volatility||PE Ratio|
|Accident & Health Insurance||44.03%||9.67|
|Air Freight/Delivery Services||43.54%||5.08|
|Assisted Living Services||53.87%||14.38|
|Auto Parts: O.E.M.||41.07%||17.13|
|Biotechnology: Biological Products (No Diagnostic Substances)||111.05%||45.32|
|Biotechnology: Commercial Physical & Biological Research||110.13%||27.84|
|Biotechnology: Electromedical & Electrotherapeutic Apparatus||62.78%||47.93|
|Biotechnology: In Vitro & In Vivo Diagnostic Substances||110.61%||19.77|
|Biotechnology: Laboratory Analytical Instruments||89.65%||9.08|
|Computer peripheral equipment||83.97%||20.06|
|Computer Software: Prepackaged Software||112.17%||43.72|
|Consumer Electronics/Video Chains||155.48%||35.05|
|Department/Specialty Retail Stores||83.54%||27.37|
|Diversified Commercial Services||50.40%||28.07|
|Diversified Financial Services||72.81%||8.97|
|Electric Utilities: Central||47.28%||25.44|
|Engineering & Construction||69.18%||33.56|
|Finance: Consumer Services||56.96%||7.15|
|Internet and Information Services||59.87%||16.51|
|Managed Health Care||47.05%||56.77|
|Natural Gas Distribution||50.47%||19.04|
|Oil & Gas Production||62.40%||27.73|
|Ordnance And Accessories||77.24%||10.66|
|Other Consumer Services||42.07%||47.95|
|Other Metals and Minerals||89.21%||11.58|
|Other Specialty Stores||127.77%||18.67|
|Pollution Control Equipment||54.28%||25.08|
|Property Casualty Insurers||46.69%||9.3|
|Radio And Television Broadcasting And Communications Equipment||123.14%||26.55|
|Real Estate Investment Trusts||75.58%||56.17|
|RETAIL: Building Materials||66.18%||13.69|
|Retail: Computer Software & Peripheral Equipment||73.85%||23.1|
|Service to the Health Industry||78.43%||14.77|
|Services Misc. Amusement & Recreation||29.34%||11.84|
|Trucking Freight/Courier Services||68.96%||21.27|
|Trusts Except Educational Religious and Charitable||21.76%||10.85|
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