The price-to-earnings ratio, or PE ratio, is one of the most commonly used financial metrics, but it’s not necessarily the best understood. It is calculated by dividing the current price by earnings per share.
When trailing earnings per share for the last 12 months are used in the calculation, the ratio is referred to as the trailing PE ratio. When using earnings estimates for the next four quarters, the ratio is referenced to the forward PE ratio.
The PE ratio is often misused as a measure of stock value. A stock’s intrinsic value is calculated using the company’s economic fundamentals, not its price. Price is what one investor is willing to pay another at any time. As Warren Buffett noted – price is what you pay, value is what you get.
However, the price-to-earnings ratio is often used as a quick and easy relative measure of stock value by comparing the stock’s current price-to-earnings ratio to that of its market sector and that of the market as a whole. Online broker websites should provide this information. This comparison provides information on whether the stock is undervalued or overvalued.
The ratio typically varies from as low as four to as high as 30, but some companies may have P/E values outside of this range. A P/E of 15 means the stock price is 15 times the company’s annual earnings. That means it would take 15 years of income to cover the price paid. This can be expressed by the equation…
Share price = P/E x earnings per share
One way to use the price-to-earnings ratio is to consider a stock a potential buy when its price-to-earnings ratio is near the low end of its average annual range. At this point, the price is more likely to be near or below its intrinsic value.
However, because the price-to-earnings ratio isn’t an absolute measure of value, these are estimates unless you can more accurately estimate the stock’s fair value based on company fundamentals.
A number of factors can affect the price-to-earnings ratio. P/E may be depressed because the entire market has taken a downturn as a result of a global recession, or fears of one happening. In this case, the low P/E ratio may have nothing to do with the company’s individual performance, and the company may represent an excellent buy.
On the other hand, the depressed value may be related to a factor that the market has decided will affect the future profits of the company in question. Reading the company’s annual and interim reports and market announcements would be useful exercise.
All stocks exhibit a range of P/E values over the course of a year as the stock price fluctuates. Much of the fluctuation in a stock’s price-to-earnings ratio is due to market noise and has little to do with a stock’s value.
Buying a stock when its P/E ratio is at the low end of its average annual fluctuation ensures that the stock’s price will rise as P/E ratios rise (if they do) and the company’s earnings grow (if they do). increases over time according to the formula above.
For that reason, investors should be careful to buy stocks that are showing good earnings-per-share growth and whose current price-to-earnings ratios are at the low end of their average annual range. Also, a high return on equity and low debt should be a requirement for any stock purchase.