What is Price / Earnings Ratio?

The P/E ratio (price-to-earnings ratio) of stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.

A higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio

The P/E ratio has units of years, which can be interpreted as “number of years of earnings to pay back purchase price”, ignoring the time value of money. In other words, P/E ratio shows current investor demand for a company share. The reciprocal of the PE ratio is known as the earnings yield. The earnings yield is an estimate of the expected return to be earned from holding the stock.

Price-to-earnings ratio is popular in the investment community. Earnings power is the primary determinant of investment value. The P/E ratio can be calculated with the following formula:

PE = Market Price per Share / Earnings Per Share

There are a number of variants on the basic PE ratio in use. They are based upon how the price and the earnings are defined.

Price: is usually the current price is sometimes the average price for the year

Earnings Per Share (EPS):

  • earnings per share in the most recent financial year
  • earnings per share in trailing 12 months (Trailing PE)
  • forecasted earnings per share next year (Forward PE)
  • forecasted earnings per share in the future year

Also read: What is Sharpe Ratio?

Trailing P/E or P/E TTM

Earnings per share is the net income of the company for the most recent 12 month period, divided by the number of shares outstanding. This is the most common meaning of PE ratio if no other qualifier is specified. Monthly earning data for individual companies are not available, so the previous four quarterly earnings reports are used and EPS is updated quarterly.

Note: Companies individually choose their financial year so the schedule of updates will vary.

Trailing P/E from continued operations

Instead of net income, this method uses operating earnings which exclude earnings from discontinued operations, extraordinary items (e.g. one-off windfalls and write-downs), or accounting changes.

Forward P/E or Estimated P/E

Instead of net income, this method uses estimated net earnings over the next 12 months. Estimates are typically derived as the mean of a select group of analysts (note: selection criteria is rarely cited). In times of rapid economic dislocation, such estimates become less relevant as “the situation changes” (e.g. new economic data is published and/or the basis of their forecasts become obsolete) more quickly than analysts adjust their forecasts.

A. Sulthan

Author and Assitant Professor in Finance

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