Being able to get a sense of whether a stock is overvalued or undervalued can help investors arrive at an informed decision. One of the ways this can be accomplished is by focusing on the ratio of its share price to its earnings per share. This is the price-to-earnings ratio, also known as P/E Ratio, P/E, or PER. It is a widely used ratio that indicates what the market is willing to pay for a stock.
The P/E Ratio can help you assess whether a stock could be a sound investment and assist in the creation of a strong portfolio.
How is the P/E Ratio calculated?
Arriving at the P/E Ratio is quite straightforward. You simply divide the market value or price per share by the company's earnings per share.
|P/E Ratio = Share price
Earnings per share
Let's say the price per share is $30 and the earnings per share are $1.5.
|P/E Ratio = 30 = 20
The earnings per share (EPS) can be calculated by dividing the company's net earnings available to common shareholders by weighted average shares outstanding over a certain period of time. Typically, the last twelve months are taken into consideration.
EPS = (Net Income – Preferred Dividend) / Weighted Average Shares Outstanding
Shares outstanding is the total number of shares owned by investors as well as restricted shares held by employees and company officials. The number of outstanding shares of a company may change at various times during the year. Several events such as new share issues, the exercise of stock options, conversion, and cancellations through buybacks may change this number.
It's worth noting that the P/E Ratio of a stock isn’t particularly helpful when viewed in isolation. To gain valuable insight, you need to compare it against the stock’s historical P/E or a competitor’s P/E.
Trailing P/E Ratio
This ratio accounts for a company's actual earnings. The Trailing P/E Ratio is calculated across a period of previous quarters. If the company in question has reported their earnings accurately, the trailing P/E Ratio can offer a more precise valuation. It should, however, not be used as an indicator of future performance.
|Trailing P/E Ratio = Current share price
EPS from the previous year
Forward P/E Ratio
The Forward P/E Ratio is calculated by estimating the net earnings of upcoming or future quarters. It is essentially the company's best estimate of future earnings and can be found in the earnings release by the company or from analysts’ estimates. As an investor, you can compare current earnings to future earnings and hopefully get a clearer picture of what growth may look like. However, this metric can be problematic as analysts could underestimate or overstate the estimated future earnings.
|Forward P/E Ratio = Current share price
Estimated future EPS
How investors use P/E ratio
PE ratios are often used in Fundamental Analysis, which is a method for analyzing and evaluating a company’s stock. Investors seek out companies with high P/E Ratios that are sometimes called growth stocks.
While growth stocks can provide considerable capital appreciation if the company experiences the expected growth by investors, leading to an increase in the share price, they can also be:
- Quite volatile and a risky investment.
- Overvalued due to the stock's price being high relative to earnings.
- The high P/E Ratio may simply be a result of having a large amount of investment capital.
On the other hand, companies with low P/E Ratios are known as value stocks. Value stocks are considered by investors as stocks currently being sold at a discount. However, they can be:
- Undervalued as their stock prices trade lower relative to fundamentals.
- In a slow growth phase due to market conditions.
If a company is newly listed or has not yet reported earnings, the P/E Ratio may be indicated as N/A which means that the ratio is not available or not applicable to the company's stock. It could also mean that the company has zero or negative earnings.
The P/E Ratio works best when comparing companies within the same sector.
On a final note
There are many financial ratios that are used in fundamental analysis that can help you determine a more accurate value of a company’s stock. Several investors use the P/E ratio as part of the research process, as it helps them figure out if they are paying a fair price for a stock. However, the P/E Ratio should not be the only metric you use to make an investment decision. It is important to consider a variety of other ratios in your research process for more informed decision making.