What is Price to Earning Ratio: Interpreting P/E Ratio of a stock

P/E ratio is a very popular term amongst stock investors. Anybody who is considering investing in stocks does usually find out the P/E ratio of the stocks he is researching. At the same time, strange as it may sound, very few people are able to use the P/E ratio well in their investment decisions. In this post, we will try to understand what P/E Ratio means and how it can help an investor make sound investment decisions.

Calculating PE Ratio:

First things first, let’s understand how we arrive at the P/E ratio of a stock. The formula is

P/E Ratio = Stock Price/ Earning Per Share

Let’s say that a stock has annual Earning per Share of $10, and is trading at $120. In this case, the P/E ratio will be 12. A conservative investor will prefer using earnings from the previous four quarters, while calculating P/E ratio. In fact you can choose to take an average of last 3-5 years of annual earnings, if you really want to act like a true value investor. Averaging helps remove aberrations from the earnings of a stock. However, many analysts consider expected earnings for the next four quarters. A flaw, that too a major one, with this approach is that expected earnings are ‘EXPECTED’ earnings. They can change faster than your mood. And then, everybody has different expectations.

Interpreting PE Ratio:

Simply put, in the example above, assuming that the stock returns the same level of earnings year after year, you should get back your money in 12 years. If you reverse the PE ratio, you will get the Earning Yield of the stock. Earning Yield is a measure of the return from a stock. In this example, you are getting a return of 100/12 or 8.3% per annum on your investment. Remember that all earnings of a company belong to shareholders. Irrespective of what dividend is being paid out to shareholders in the short term, ultimately all the earnings should flow back to the shareholders. Earning yield is a good measure to consider if you are thinking about choosing between other investment options and stocks for investing your money.

P/E ratio gives you an idea of what the market is willing to pay for the company’s earnings. By relating share prices to actual profits, the P/E ratio highlights the connection between the price and recent company performance. If prices get higher and profits too move up, the ratio stays the same. The ratio moves only when price and profits become disconnected.

For this reason, when the P/E ratio is higher or lower than normal we know that recent profit levels are no longer the main factor in pricing. This might be because market is expecting a change – a change in the performance levels of the company in either direction going forward or a change in the market sentiment. You must make a note of these changes.

A higher P/E means that the market is willing to pay more for a stock compared to another stock with a lower P/E. An interpretation of a high P/E could be that the stock is overpriced. On the other hand, this could also mean that the market has high hopes from the stock in future, and it is factoring in the future earnings of the stock in its current price. Similarly, a low P/E may indicate a stock with low expectations from the market or it could mean an undervalued stock that has been overlooked by the market. Value investors hunt this kind of undervalued stock. Note, however, just because a stock is trading at a low P/E does not mean you should buy it. If it is an undervalued stock, it might be a good bargain. However, if it is a stock, which is not expected to do well in future, you may want to do a little research before you buy it.

You should, however, never consider P/E ratio in isolation. It’s a good measure if you use it for comparison between competitors or with the market or with the same company at different points in time. However, if you choose a telecom company over a steel company based on the difference in their P/E ratio, it may not be a very fruitful exercise.

Different types of P/E Ratios:

Many analysts will use different types of P/E ratios resulting in utter confusion. These can be trailing P/E ratio based on earnings of the last four quarters or forward P/E ratio based on expected earnings of the next four quarters. Using past earnings might not be a great indicator of the future earnings of a stock. However, in reality, past earnings have been better indicators of the future earnings of a stock than the earning forecasts made by stock analyst. It’s not easy to manipulate the value of trailing P/E ratio, as there is no guesswork or wishful thinking involved in calculating it, which is why value investors prefer using trailing P/E while making their investment decisions.

I hope the above post is able to give you a basic understanding of the P/E ratio. The next question in your mind could be what the right P/E for a stock is. I will answer this question in my next post. Stay tuned.