MASTERCLASS Investment – PE – What is Price to Earnings Ratio and how do you use Price to Earnings Ratio

Investment – PE – What is Price to Earnings Ratio and how do you use Price to Earnings Ratio

What is Price to Earnings ratio? – The PE of a stock (Price to Earnings Ratio) is a measure or ratio (one figure divided by another) using a company’s current share price compared to its earnings per share, also known as “price multiple” or “earnings multiple”.
PE is known as the “multiple”, because it shows how many multiples of the earnings per share investors are willing to pay for every dollar of earnings. For example, a company with a multiple (PE) of 16, means investors are willing to pay $16 for $1 of current earnings (profit, note sometimes pre-tax earnings are used in some formulas).

How PE is calculated:

Price to Earnings = current Share Price  /  Earnings per Share (EPS)

(ie currents share price divided by earnings per share).

If a company is currently trading at $23 a share and earnings per share (EPS) over the last 12 months were $1.50 per share, the P/E ratio for the share would be 15.33 ($23/$1.50).
The EPS used is usually based on the last four quarters (giving a “trailing PE”), or sometimes it can also be based on the estimates of earnings expected in the next four quarters (giving a “projected” or “forward” PE). Another variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

Understanding how the analyst calculates PE, or doing your own PE raises the need for consistent method to ensure company PE comparisons are valid and reliable (compare apples with apples).

Another aspect to watch – the denominator (EPS) is based on an accounting measure of earnings that can be manipulated, making the PE only as good as the quality of the underlying earnings number.

How it helps Investors –

Generally, a high PE suggests that investors are expecting higher earnings growth in the future compared to companies with a lower PE, because the price is going up or higher in proportion.

Note, the P/E ratio doesn’t tell us the whole story. It’s usually more useful to compare the PE ratios of one company to other companies in the same industry or sector, to the market in general or against the company’s own historical PE. For example,  PE should not be used as a basis for investment to compare the PE of a technology company (high PE) to a utility company (low PE) as each industry has much different growth prospects and business models.

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