Price to Earning Ratio
From Financial Literacy Wiki
The Price to Earning Ratio (commonly known as PE Ratio) of a stock (also called its "earnings multiple", or simply "multiple", "P/E", or "PE") is a measure of the price paid for a share relative to the income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income. It is a valuation ratio included in other financial ratios. The reciprocal (or inverse) of the P/E ratio is known as the earnings yield.
By relating price and earnings per share for a company, one can analyze the market's stock valuation of a company and its shares relative to the income the company is actually generating. Investors can use the PE ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal, it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, countries, and time periods may be misleading.
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Calculation
Typically, it is just the price per share divided by the earnings per share.
The price per share (or numerator) is the market price of a single share of the stock. The earnings per share (or denominator) is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. The earnings per share (EPS) used can also be the "diluted EPS" or the "comprehensive EPS".
For example, if stock X is trading at $24 and the earnings per share for the most recent 12 month period is $3, then stock X has a PE ratio of 24/3 or 8. Put another way, the purchaser of stock A is paying $8 for every dollar of earnings. Companies with losses (negative earnings) or no profit have an undefined PE ratio (usually shown as Not applicable or "N/A"); sometimes, however, a negative P/E ratio may be shown.
There are three types of PE Ratio which vary according to how earnings per share is calculated:
- Current
- Trailing
- Forward
Current
The earnings per share that you use is the earnings expected by analysts for this year.
Forward
The earnings per share that you use is the earnings expected by analysts for next year.
Note that the Forward and Current PE Ratio is as good as the the analysts making those projection. What you can do is to take the average of analysts' predictions for your decision making.
Trailing
The earnings per share that you use is what is earned by the company in the last four quarters or a year. It give you an insight into the company's earning ratio based on accurate historical data.
Interpretation
Normally, stocks with high earning growth are traded at higher PE values. For example, stock X may be expected to earn $6 per share the next year. Then the forward PE ratio is $24/6 = 4. So, you are paying $4 for every one dollar of earnings, which makes the stock more attractive than it was the previous year.
It is usually not enough to look at the PE ratio of one company and determine its status. Usually, an analyst will look at a company's PE ratio compared to the industry the company is in, the sector the company is in, as well as the overall market (usually the Straits Times Index). Often, comparisons will also be made between quarterly and annual data. Only after a comparison with the industry, sector, and market can an analyst determine whether a PE ratio is high or low with the above mentioned distinctions (i.e., undervaluation, over valuation, fair valuation, etc).
Never ever make a decision based solely on the PE ratio alone but nevertheless, a negative PE Ratio or a zero PE Ratio is a major sign of trouble, an indication that the company is not profitable anymore.
