What is a P/E Ratio and Why Does it Matter?

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Stock investors are constantly searching for ways to determine whether a stock is under- or over-valued. Logically, they seek to buy securities in companies that are under-valued and sell the securities of companies that are over-valued. The Price Earnings (P/E) Ratio is a common way to quickly assess how investors value a company based upon its future earnings projection.

Calculation of P/E Ratio

The P/E ratio is the result of dividing the common stock market price by its reported or projected earnings per share. For example, the common stock of XYZ Corporation sells for $22 per share. The latest reported annual earnings are $1.75 per share. The P/E ratio of XYZ would be 12.6 ($22 divided by $1.75). Price earnings ratios are used to compare different companies or the same company over different time periods.
 
Companies with higher P/E ratios are expected to have higher rates of future earnings growth. For example, web-based Amazon (AMZN) had a P/E ratio higher than its brick-and-mortar competitor Walmart (WMT) even though the latter’s earnings per share (EPS) were more than seven times greater than Amazon’s in 2015. Simply stated, investors are willing to pay more today for a dollar of Amazon’s earnings than a dollar of Walmart’s earnings because they believe Amazon’s earnings per share in the future will grow faster than Walmart’s.
 
P/E ratios can vary substantially based upon the earnings components used to calculate the ratio. Most analysts seek to understand and project operating earnings, rather than total earnings that may include extraordinary events unlikely to recur.
 
In the example of XYZ, the reported earnings of $1.75 per share included the sale of a division that added the equivalent of $0.30 per share to the final earnings result. Securities analysts typically deduct the financial impact of extraordinary events to arrive at a true operating profit. In this case, reported earnings of $1.75 would be reduced by $0.30 to get operating earnings per share of $1.45 and the newly calculated P/E ratio would be approximately 15 ($22/$1.45).
 
Price earnings ratios can also vary according to three factors:
 

  • Trailing Actual Earnings. Earnings may be for the latest reported calendar year or adjusted as each quarter is reported. For example, a year includes quarters 1, 2, 3, and 4 of the most recent year. When the first quarter of the new year is reported, the analyst would omit quarter 1 of the previous year and add quarter 1 of the current year so the annual earnings would include quarters 2, 3, and 4 of the previous year and quarter 1 of the current year. This approach ensures that the analysts are using an earnings figure for the most recent 12 months.
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  • Projected Earnings. Sometimes referred to as a “Forward P/E,” the earnings figure is based upon an analyst’s estimated earnings per share over the next 12 months. The projected earnings may be the opinion of a single analyst or a consensus of a number of analysts. It is important to know who is making the estimate and that person’s qualifications to ensure that projected earnings are realistic.
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  • Combination of Actual and Projected Earnings. Some analysts may use two quarters of actual earnings and two quarters of projected earnings to arrive at an earnings per share number.

 

Testing the Validity of the Price Earnings Ratio

Theoretically, companies with higher rates of annual earnings growth have higher P/E ratios. From time to time, investor optimism pushes the price of a security to unrealistic highs with expectations of excessive growth. Using the Price/Earnings Growth (PEG) ratio is a quick and easy way to determine whether the P/E ratio is justified or if a security is over-, under-, or fairly priced based upon your expectation for its average annual growth during the next five years.
 
The PEG is calculated by dividing the Price Earning ratio by the projected annual five years earnings growth (a three-year period can also be used if desired). For example, Company B’s stock selling at a 13 P/E with an estimated annual growth rate of 25% per year would have a PEG of 0.52 (13/25) while Company A’s stock selling at a 10 P/E with an estimated annual growth rate of 25% would have a PEG of 0.4 (10/25). Analysts consider a ratio less than 1.0 as under-valued, equal to 1.0 fairly valued, and over 1.0 as over-valued. While the shares of both companies are undervalued based upon their projected earnings growth, Company A would be the better purchase due to its lower PEG ratio.
 
As with all indicators, neither the P/E nor the PEG are completely reliable, especially since stock prices are rarely rational in the short-term. It is this volatility that provides opportunities to buy and sell.
 
Nonetheless, it’s important to recognize that companies with very low earnings can provide skewed results. It is much easier for a company earning a million dollars to grow 100% per year for five years to $16 million than a company earning $100 million to grow to $1.6 billion in profit. When establishing a projected earning growth rate, consider your own common sense as well as any public estimates of growth from reliable analysts.

Limitations of the P/E and PEG Ratios in Analysis

Both ratios are simple and easy to calculate, but are best used as general indicators of value due to their superficiality. Their limitations in deterring value include the following:

  • Calculations of Company Earnings Are Complex and Frequently Managed by Corporate Executives. Accounting and tax rules are complicated and constantly changing, making comparisons between earnings of different periods and companies difficult. Since the market typically rewards higher P/Es to companies with a trend of consistent earnings growth than companies with erratic earnings, corporate executives try to manage reported earnings to meet investor expectations and maintain high stock valuations.
  • High Growth Rates Cannot Be Extended Indefinitely. Extraordinary earnings growth is difficult to achieve as companies mature. Competitors recruit company employees, leapfrog technologically, and capture market share from industry leaders. Additional suppliers generally reduce product or service prices and profit margins. As companies grow larger and grow staff, reacting to changing market conditions is more difficult, making them more vulnerable to those very market conditions.
  • P/E Multiples Tend to Fall Over Time. Earnings projections tend to be optimistic. When earnings projections are not met, ratios tend to contract.
  • Some Companies Are Not Valued Based on Their Earnings. Entrepreneurial companies like Facebook (FB) and Amazon spend heavily in their early years to capture a dominant market share, thereby delaying earnings. Natural resource companies invest heavily in exploration activities to find assets that will be converted to cash in future years. Since those activities are generally expensed in the year they occur, the company produces accounting losses even though assets may grow signficantly.
  • Financial Leverage Impacts Earnings. P/E ratios consider only the equity of a company, not its entire capital base. Leverage, using debt in the capital structure, increases shareholders’ risk since debt has a multiplier effect when earnings on the borrowed capital exceed the cost of that capital. Conversely, when the rate of earnings is lower than the cost of borrowed capital, shareholder losses are exaggerated. Looking at a P/E ratio without considering the debt owed by the company often leads to invalid results.
  • P/E Ratios May Be Misleading. While a low P/E ratio may indicate an under-valued, over-looked opportunity for profits, it can also mean that the company’s earnings will decline in the future and astute investors are selling the stock to avoid losses. Relying on P/E ratios alone to buy or sell stock is a risky and foolish practice.

Final Thoughts

P/E ratios are excellent tools for a superficial analysis such as determining which company in an industry to further investigate or selecting one industry over another. Nevertheless, it is important to ascertain the underlying reasons for a multiple before making an investment decision.
 
In the short-term, stock prices can be very volatile since they reflect investor hopes and fears. For example, a suspected change in an analyst’s opinion or rumors about the economy, an industry, a company, or its competitors affect stock prices and P/E multiples whether valid or not. P/E and PEG ratios should always be used with other metrics before taking investment action.

Mike Lewis | August 29, 2018 in Economy, Entreprenuers, Investments, MoneyCrashers, Personal Finance

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