What is P/E Ratio?
The P/E Ratio, or “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.
How to Calculate P/E Ratio (Step-by-Step)
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 price-to-earnings ratio of a company is then typically compared to its peer group.
If you’re evaluating a potential investment, comparisons to other companies in the same industry can be helpful in determining whether a stock is currently undervalued or overvalued.
Calculating 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.
Price Earnings Ratio Definition (Source: SEC.gov)
Learn More → Valuation Multiple
P/E Ratio Formula
The formula for calculating the price-to-earnings ratio is as follows.
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).
Quick P/E Ratio Calculation Example
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 = 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.
Price to Earnings Ratio Formula (P/E)
The price to earnings ratio can also be calculated by dividing the company’s equity value (i.e. market capitalization) by its net income.
While the two formulas we’ve discussed thus far are conceptually the same, the answers usually vary marginally from one another due to a minor discrepancy:
- Earnings Per Share (EPS): The earnings per share (EPS) metric is calculated by using the weighted average number of shares (i.e. beginning and ending period average).
- Net Income: In contrast, the net income is the accounting profitability of a company that measures operating performance across a period of time.
Trailing vs. Forward PE Ratio: What is the Difference?
There are two common variations of the P/E ratio:
- Trailing P/E Ratio: The price-to-earnings ratio is calculated using the earnings from the actual performance in the last twelve months (LTM).
- Forward P/E Ratio: The price-to-earnings ratio is calculated using the upcoming, forecasted net earnings of a company.
Price to Earnings Ratio: Pros and Cons Analysis
Using a P/E ratio is most appropriate for mature, low-growth companies with positive net earnings.
The price-to-earnings 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 price-to-earnings 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 Chart: Definition, Interpretation and Issues
Price to Earnings Commentary Slide (Source: WSP Trading Comps Course)
What is a Good P/E Ratio? (Higher or Lower)
Determining whether a company is undervalued, overvalued, or correctly priced by the market requires more in-depth analysis and benchmarking to a variety of valuation multiples of comparable peers.
- High P/E Ratio: A higher 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 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, namely when compared to the target company’s industry peers.
Learn More → Price Earnings Ratios by Sector (Source: Damodaran)
How Leverage Impacts Price Earnings Ratio (Capital Structure)
The price-to-earnings ratio of similar companies could vary significantly due to differences in financing (i.e. leverage).
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, increased risk and interest expense could cause the price-to-earnings ratio to decline, while well-structured reinvestment for growth could cause the P/E ratio to increase and offset the downsides of using debt.
For companies, the reliance on more 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.
Similar to all other financial metrics, the price-to-earning ratio should not be used alone to make investment decisions.
