The Price to Earnings (P/E) ratio
compares a corporation's current stock price to the earnings
per share that it yields. For instance, if a corp's stock
is currently trading for $46 and earnings per share over
the last 12 months have been $2, then the P/E ratio is
$46 / $2 = 23. In general, the formula for Price to Earnings
Ratio is:
Current
Per Share Market Value
Earnings
Per Share |
or
Average
Common Stock Price
Net
Income Per Share |
The denominator, Earnings Per Share,
is derived from the financial statements of the company
over the last 4 quarters. Also, the EPS can be derived
from estimates of the 4 upcoming quarters.
If you buy a stock at a P/E ratio
of 15, this means it will take you 15 years of earnings
derived from that stock in order to cover up your original
investment. In other words, you'll get a "payback
in 15 years." Consider a corp that earned $15 million
last year and had earnings per share of $15 with 1.5 million
shares outstanding. If the current trading price of the
stock is $150, this means the firm's P/E Ratio is = $150
/ $15 = $10. This can also mean the investors are willing
to pay $10 for every $1 of earnings derived from that
stock.
Drawbacks of Using the P/E Ratio
1) The Price to Earnings Ratio is
based on future estimates of earnings, example the upcoming
4 quarters of earnings to calculate the EPS (Earnings
per Share). With a very volatile and fast changing economy
that we are currently in, estimates of future accounting
earnings should be taken with a grain of salt.
2) The Accounting Multiplier used
is a debatable issue. Should analysts use the industry
average, expected
growth return model or Weighted
Average Cost of Capital model?
3) Since the Earnings Per Share is
sometimes calculated using the last 4 Quarter's Earnings
(old data), this may not fully represent the present condition
of the firm. Price to Earnings Ratio calculated in this
manner is also known as a "Trailing P/E."
Interpretations of Price to Earnings
(P/E) Ratio
| N/A |
Company with No Earnings has a N/A P/E
Ratio |
| 1 - 13 |
Stock is in decline (undervalued) or company's earnings
are projected to go down |
| 14 - 20 |
Fair value for majority of corporations |
| 21 - 28 |
Stock is overvalued or the company's earnings have
significantly increased since the last earnings statement
was presented |
| 28+ |
Stock may be subject to a speculative "bubble
burst" and is highly overvalued. |
