The price-earnings (P/E ratio) is a commonly used and oft-cited calculation for determining a company’s value, but it is mostly misunderstood. The P/E ratio is only useful for comparing similar companies in the same industry with similar business models. It should not be used to compare radically different businesses.
16 Steps to Master the P/E Ratio
What is the P/E Ratio?
The Price-Earnings Ratio (P/E Ratio or PER) is a formula for performing a company valuation. It is calculated by dividing the current stock price by the previous 12 months’ earnings per share (EPS). A P/E Ratio of 12 means you would pay $12 for every $1 of earnings if you invested. It should only be used to compare companies in the same industry.
How to Calculate The PE Ratio
The P/E Ratio has two parts.
Part 1. Calculate the Earnings per Share. EPS = (Earnings or Net Income for the previous 12 months) divided by (Number of Shares Outstanding)
Part 2. We can now calculate the P/E Ratio. P/E Ratio = (Current Share Price) divided by (Earnings per Share EPS)
The PE Ratio Formula
What Does the PE Ratio Mean?
The P/E ratio enables you to understand how much it will cost you to buy a portion of the companies profit. If a company has a P/E Ratio of 25, this means it will cost you $25 for each $1 of company profit. This point can be challenging to understand, so let me make it very simple.
Imagine you want to by an Icecream Stand. The Owner wants to sell that stand to you for $10,000. The Icecream Stand makes a yearly profit after tax of $2,000. This means if I want to buy this profit of $2,000, it will cost me $10,000. So the P/E Ratio is $10,000 / $2,000 = 5. In other words, it would take me five years to make my money back on this investment.
This is what the P/E Ratio or the “Multiple” tells us. In the example above, I used the case of buying a whole business, and we are considering all of the profits. The P/E Ratio achieves this same goal by using the Individual Share Price / Earnings per Share as we are not buying the whole company just a portion of it.
The P/E Ratio can tell you what kind of premium investors are willing to pay to get a piece of this company. P/E Ratios should always be considered in the context of the industry group.
How to Use the Industry PE Ratio?
P/E Ratios are best deployed to compare companies within the same industry. Some industries may have a very high average P/E Ratio and some a very low P/E Ratio, depending on where the industry is in its lifecycle. If an industry is new, fast-growing, and requires a lot of investment, the P/E ratio may well be high on average, such as the Big Data Analytics industry. If an industry is stable and slow-growing, the average P/E ratio may be lower, for example, the Utilities Industry.
This makes comparing companies in different industries with the P/E ratio, not advisable.
What is a Good PE Ratio?
There is no such thing as a good P/E ratio for all companies; however, we can say that a PE Ratio in general under 25 is ok and suggests the company is reasonably priced. A P/E Ratio over 200 would indicate the company share price is way in excess of the company’s ability to generate matching profits.
Is a Company Cheap, Fairly Priced, or Overpriced?
The Price to Earnings ratio is a simple calculation that may take a little bit of time to understand. But once you understand it, it can be beneficial.
If you compare the P/E Ratio of companies in the same industry, this will tell you which companies are perceived to have the brightest future or the best products or services; as the investors are willing to pay more for a share of one company as opposed to another company that is in the same line of business.
Is a High PE Ratio Good?
A high P/E ratio is both good and bad, meaning it can indicate a company with a great future or indicate an excessively overpriced company. It depends on what you believe the company’s future outlook to be.
For example, Company A has a P/E Ratio of 100. If 100 is the highest P/E in the industry, then investors believe this company has the best profit growth potential in the future. This means that the market participants are willing to buy the stock because it has excellent growth prospects.
What is a High PE Ratio?
Take a look at Amazon or Netflix P/E Ratios; they regularly maintain a P/E ratio over 100. This is because investors are willing to pay higher prices for the shares because of perceived future growth. Amazon, for example, has razor-thin margins and invest so much of its revenue into penetrating new markets and building technology and logistics centers, that there is very little profit left over. This means the High Share Price dividend by the Low Earnings equals a high P/E Ratio. As investors are still willing to pay a lot for Amazon shares, the P/E remains high. If the investors lose confidence in the company’s ability to continue growing at a fast pace, they would experience fear, sell the stock, and the stock price would crash. This means with a lower stock price, the P/E Ratio would also drop to something more reasonable.
High P/E Ratios usually mean high growth potential, but if investors lose confidence the stock price can plummet.
What is an Average PE Ratio?
Company B has a P/E of 25; if 25 were the industry average, then this company would be seen as a fair value for the industry. This essentially means the investors think this company is neither a high-performance, high growth stock, nor an underperformer with fewer profits compared to the competition.
Is a Low P/ Ratio Good?
Again a low P/E Ratio can be good or bad based on the context. A low P/E can be good if the company has grown profits in a growing market, it could indicate that the broader market participants have not realized that this company has a very low valuation compared to its peers. This is what income investors or value investors like Warren Buffett look for when buying shares in a company. A company with a low P/E and excellent growth and profitability. As the profits grow, other investors will see that this company is a bargain, and the stock price due to the demand of the buyer will start to increase.
When is a Low PE Ratio Bad?
A low P/E ratio can be bad when the company in question is in a declining market, and the future prospects are bleak. As profits decrease, so does the stock price as the current investors are selling the stock, and the demand for the stock is decreasing also. This is why the earnings season is so important.
A Low PE Ratio example
Company C has a low P/E of 5 compared to the industry average of 25. This company would be seen as an underperformer / or a stock with potential value. If the earnings suddenly jumped for this stock, this could potentially be a good bargain. However, negative earnings would adversely impact the P/E Ratio, meaning if the profits reduced, the P/E ratio would increase, which means the stock price would need to fall to compensate for it.
The P/E Ratio needs to be combined with other fundamental measures to get a much better picture of the stock.
Is there a Negative PE Ratio?
Answer: Yes. A company can have a negative P/E Ratio if it has not made any profit in the previous year. But it is not possible to put a value or number on the ratio because the P/E ratio consists of Price divided by Earnings, and if there are no earnings, the formula does not work. You will often see the P/E ratio reported as N/A or simply blank.
What is the PE Ratio TTM?
The P/E Ratio TTM refers to the P/E Ratio for the Trailing Twelve Months; this means the price divided by earnings is calculated based on the previous 12 months. The TTM is different from the calendar year, which is from January 1st to December 31st.
What is the Forward PE Ratio?
The forward P/E Ratio is calculated based on the current stock price divided by the estimated earnings of the company for the next full financial year. This is only an estimate and is calculated based on the average earnings expectations of either a group of analysts or the company’s earnings forecast for the next fiscal year.
Are FAANG Stocks Overpriced or Fair Value
- Facebook P/E Ratio 28
- Amazon P/E Ratio 143
- Apple P/E Ratio 14.8
- Netflix P/E Ratio 135
- Google (Alphabet) P/E Ratio 26.5
The P/E Ratio is essentially measuring how many years it would take the company to buy all it’s stock back with its earnings. The value of all the shares divided by the profits of the company. Depending on the particular industry, a P/E ratio may vary, but a typical valuation sought after by a value investor would be something below 20. So compared to that, the FANG’s could be considered overpriced.
But we do need to be clear that these are not normal companies; they are still considered fast-growing technology stocks, with relatively low costs, high earnings, and even higher earnings potential.
While Facebook & Google have a reasonable P/E Ratio, and Apple could almost be considered a bargain, both Amazon and Netflix seem to be extremely overpriced. One of the reasons for this is they are plowing all revenue back into the business to fuel the fast growth. This reduces the earnings (after expenses) and makes them look on the surface overpriced.
How to use the S&P500 P/E Ratio (Shiller Formula)
You can also use the P/E ratio to assess if the market is good value, fairly priced or overpriced. The chart below shows the Robert Schiller calculation for the P/E ratio of the S&P500 for the last 100 years. You can see that a P/E around 20 is fair value, while very excessive P/E valuations have typically been following by crashes or readjustments.
Shiller P/E ratio for the S&P 500. The Price-earnings ratio is based on average inflation-adjusted earnings from the previous ten years, known as the Cyclically Adjusted P/E Ratio (CAP/E Ratio), Shiller P/E Ratio, or P/E 10 FAQ. Data courtesy of Robert Shiller from his book, Irrational Exuberance.
The Market (2018) is approaching a very high valuation historically, up there with the 1929 great depression and the Dotcom bust. Interestingly the Financial Crisis was not due to the overvaluation of the stock market but the integrity of the financial system itself. It is a good thing this was a greatseason because if it was not, there could be a severe pullback or readjustment.
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P/E Ratio Summary
Having some knowledge that a company will not be declaring bankruptcy anytime soon is the minimum goal; however, the more refined investor will be looking for stocks that are reasonably priced, have low amounts of debt or at least the ability to easily repay that debt, strong sales growth or revenue growth, a decent amount of cash in the bank, and stable earnings.
Also, if you are familiar with the company’s product and how important that product is to the business can give you additional insight.
Learn More About the Price Earnings Ratio & All the Fundamental & Technical Analysis Theory
This is an excerpt from the Liberated Stock Trader Book and accompanying Training Course. Chapter 4 – Section 4 – The P/E Ratio
Other Chapters of the Liberated Stock Trader Book are listed below
This chapter sets the stage for the two key areas of stock market technical analysis and the fundamental analysis of companies including macro and micro economics
This chapter looks at what REALLY makes the markets move, what causes boom and bust cycles and how to spot them.
What are stock market cycles and the cycles of business and economies. Important information that you need to appreciate as part of your core analysis.
Next we move into fundamental analysis and the financial fitness of a company. All the major indicators and measures are covered.
Stock screening means using criteria to short list the kind of stock that you want to purchase. A vital part of any stock market training
Once you know the business climate, the state of the economy and you have shortlisted the stocks you want to buy. The next thing to do is the technical analysis. Even if the company looks great on paper, if the stock price is plummeting you do not want to buy it until it has bottomed out. This is called catching a falling knife. This is what chart patterns and technical analysis helps with.
Here we get into the art of drawing on charts to help you visualize the Supply and Demand on the stock, the direction of the trend and estimate how long the trend will last. Vital for you to establish buy and sell signals.
Which indicators should you use, there are literally hundreds of stock chart indicators. Each have a specific use case and application, which should you use?
Volume is a vital indicator along with price. Both of these you need to understand in granular detail, you will learn everything you need to know.
Moving to advanced technical analysis we cover indicators such as parabolic SAR and point & figure charts.
How are the market participants feeling? Positive, Negative or indifferent. Consider that 90% of people fail to beat the average market returns, sentiment indicators can be a great contrary indicator. Lean how to use them to your advantage.
Understanding how you want to invest, how much time you have and your time horizon. These questions all help you to understand what type of investor you want to be, this then enables you to select the right strategy for you. Then we move on to building your stock investing system, a critical element to your plan.