What is the Price-to-Earnings Ratio (P/E)?
The Price-to-Earnings Ratio is a common valuation metric used to measure a company’s equity value in relation to its net earnings.
Simply put, the P/E ratio of a company represents the amount that investors are currently willing to pay for a dollar of the company’s net profit.
- Under the context of corporate valuation, what is the P/E ratio used to measure?
- Which formulas are used to calculate the P/E ratio of companies?
- How does leverage in the capital structure impact the P/E ratio?
- When could the P/E ratio be misleading to investors?
In This Article
Price-to-Earnings Ratio Formula
Often referred to as the “earnings multiple,” the P/E ratio measures a company’s share price relative to its earnings per share (EPS).
Once calculated, the P/E ratio of a company is then typically compared to its peer group. If you’re evaluating a potential investment, the P/E ratio and comparisons to other companies in the same industry can be helpful in determining whether a stock is currently undervalued or overvalued.
The formula for the P/E ratio involves dividing the latest closing share price by its earnings per share, with the EPS calculation consisting of the company’s net income (“bottom line”) divided by its total number of shares outstanding.
To account for the fact that a company could’ve issued potentially dilutive securities in the past, the diluted share count should be used — otherwise, the EPS figure is likely to be overstated.
The market price of the shares issued by a company tells you how much investors are currently willing to pay for ownership of the shares. When combined with EPS, the P/E ratio helps gauge if the market price accurately reflects the company’s earnings (or earnings potential).
For instance, let’s suppose that a company’s latest closing share price is $20.00 and its diluted EPS in the last twelve months (LTM) is $2.00.
- P/E Ratio = $20.00 Share Price / $2.00 Diluted EPS
- P/E Ratio = 10.0x
The market is currently willing to pay $10 for each dollar of earnings generated by the company. Said differently, it would take approximately 10 years of accumulated net earnings to recoup the initial investment.
The P/E ratio can also be calculated by dividing the company’s equity value (i.e. market capitalization) by its net income.
While the two formulas are conceptually the same, the answers often vary from one another due to how EPS is calculated by using the weighted average number of shares (i.e. beginning and ending period average), while net income is a metric capturing performance across a period of time.
There are two common variations of the P/E ratio:
- Trailing P/E Ratio: When the P/E ratio is calculated using the earnings from the actual performance in the last twelve months, it’s called a “trailing” P/E ratio
- Forward P/E Ratio: If the P/E ratio is calculated using the upcoming, forecasted net earnings of a company, it’s called a “forward” P/E ratio
Price-to-Earnings Ratio Issues
Using a P/E ratio is most appropriate for mature, low growth companies with positive net earnings.
The P/E ratio can be rather meaningless for early-stage companies that are barely profitable or not yet profitable. Here, the P/E ratio would be a significantly large multiple and not be comparable to industry peers (i.e. as a complete outlier) — or even come out to be a negative number.
Either way, the P/E ratio would not be meaningful or practical for comparison purposes.
The P/E ratio uses EPS (or net income) in its formula, which comes with two major pitfalls:
- Accrual Accounting: EPS and net income are measures of profit under accrual accounting, and are thereby prone to differences caused by management discretion (e.g. depreciation useful life assumptions)
- Skewed by Growth: For high-growth companies, the P/E ratio is likely going to be on the higher end, which does NOT necessarily mean that the company is overvalued — instead, the valuation multiple could very well be reasonably justified (i.e. investors expect the company to increase its profitability in the future)
P/E Ratio Leverage Considerations
The P/E ratio of similar companies could vary significantly due to differences in financing (i.e. leverage).
All else being equal, if a company borrows more debt, the EPS (denominator) declines from the higher interest expense. The extent of the share price impact largely depends on how the debt is used.
For example, the increased risk and interest expense could cause the P/E ratio to decline, while well-structured reinvestments for growth can cause the P/E ratio to increase and offset the downsides to using debt.
For companies, using debt financing adds more risk to equity investors, especially considering their position at the bottom of the capital structure.
If there are two identical companies, investors are more likely to value the highly levered company at a lower P/E ratio given the higher leverage-related risks.
In practice, the P/E ratio is a widely used valuation multiple, but has its limitations in being affected by differing reporting standards, growth rates, and the capital structure of the companies being compared.
As a result, just like all other financial metrics, the P/E ratio should not be used alone to make investment decisions. Nevertheless, the P/E ratio can serve as one tool among many to help guide your decision-making rationale.
Excel File Download
Now, we’re ready to move onto an example calculation of the P/E ratio. To access the Excel file, fill out the form linked below.
Price-to-Earnings Ratio Example Calculation
In our hypothetical scenario, we’ll be using the following assumptions:
- Latest Closing Share Price: $10.00
- Last Twelve Months (LTM) Net Income: $40m
- Next Twelve Months (NTM) Net Income: $60m
- Total Diluted Shares Outstanding: 50m — Both in LTM and NTM
Since one input for calculating the P/E ratio is diluted EPS, the next step will be to divide the net income in both periods by the diluted share count.
- Diluted EPS (LTM) = $40m Net Income / 50m Shares = $0.80
- Diluted EPS (NTM) = $60m Net Income / 50m Shares = $1.20
Next, we can divide the latest closing share price by the diluted EPS we just calculated in the prior step.
- Trailing P/E Ratio = $10.00 Share Price / $0.80 Diluted EPS = 12.5x
- Forward P/E Ratio = $10.00 Share Price / $1.20 Diluted EPS = 8.3x
Upon doing so, we arrive at 12.5x for the trailing P/E ratio and 8.3x for the forward P/E ratio. A screenshot of our finished P/E ratio calculation exercise is shown below.
To determine whether the company is undervalued, overvalued, or correctly priced requires more in-depth analysis and benchmarking to a variety of valuation multiples of comparable peers.
- High P/E Ratio: A higher P/E ratio relative to that of peers can be interpreted as a potential sign that the shares of the companies are overvalued — or that investors are projecting the company’s earnings to rise
- Low P/E Ratio: A lower P/E ratio relative to that of peers suggests that the company is either undervalued or that investors expect its earnings to decline, which tends to coincide with declining growth as the company reaches maturity
While the P/E ratio is inadequate by itself, it can be a very useful metric when the situation is appropriate and if supplemented with other metrics and namely with the metrics of peers.