Definition
The price-to-earnings ratio (P/E ratio) is an essential financial indicator that helps to determine how “expensive” or “cheap” a specific firm is on the stock market. This indicator compares a stock’s current price to its earnings per share, which helps investors decide how much they are prepared to pay for each dollar of profit earned by a company.
What is the P/E ratio?
When considering an investment in a company, it is critical to understand how well it makes money. In order to do this, we use the P/E ratio (price-to-earnings ratio), which compares a company’s stock price with its earnings per share over a specific time period, often the previous year. P/E ratios allow us to determine how “expensive” the company’s stock is in terms of its profitability. This indicator may also be used to compare organizations, taking into account the varied number of shares in flow, to provide a more neutral image.
The P/E ratio tells us how “expensive” or “cheap” the shares of a specific firm are in relation to its profitability. For example, a high P/E ratio may imply that investors are prepared to pay a relatively high price for every dollar of profit generated by the company’s shares. On the other hand, a low P/E ratio may imply that the company’s shares are more affordable and cheaper in relation to its profitability.
How to calculate the P/E ratio
Simple division is used for calculating the P/E ratio:
P/E ratio = Price of 1 shareProfit per 1 share
Let’s figure out how to determine the ratio of price to earnings (P/E ratio).
The stock prices for publicly traded companies are constantly available on financial websites like Grid Capital, Yahoo Finance, and the Wall Street Journal. However, in order to fully understand how costly stocks are in relation to earnings, the P/E ratio must be considered.
Earnings per share is a key metric that businesses release regularly and annually. It tells you how much profit is accounted for per share. To calculate the P/E ratio, however, we must use yearly earnings per share. This information may be found in the most recent annual income statement of the firm. Please keep in mind that the report may be slightly out of date at the time of use since corporations often publish reports after the end of the fiscal year. In this regard, many investors choose to use profits for the “TTM” (the trailing twelve months). To do this, income data from the previous four quarterly reports must be combined.
Let’s analyze how the P/E ratio is calculated using the example of Apple:
Stock price: the price of Apple shares on August 1, 2023 was $196.45.
Earnings per share: To determine the P/E ratio, you need to take the profit for the last four quarters:
March 2023: $1.52 / December 2022: $1.88 / September 2022: $1.29 / June 2022: $1.2
Total: Earnings per share for the last twelve months = $5.89
P/E ratio: To calculate it, divide the stock price ($196.45) by earnings per share ($5.89), and get a P/E ratio = 33.35.
Keep in mind that all of this data can be found in Apple’s quarterly earnings reports available on their investor relations website.
What does the P/E ratio show?
Unlike simple items like retirement savings or the amount of chocolate in chocolate chip cookies, the P/E ratio has no clear “good” or “bad” connotation. Nothing is as obvious as it appears. However, the business’s P/E ratio reflects how investors find this company. It indicates their expectations for future profits, which may rise, remain constant, or fall.
The low P/E ratio suggests that investors believe the company’s profits will drop in the future. Assume you are an investor looking to invest in a firm that produces and sells cassettes for cassette recorders. It used to be a profitable company, and the shares of a business like this were expensive. However, due to emerging technologies such as CDs and digital music, the popularity of tape recorders has declined over time. Investors may have sold shares of this corporation in fear of a drop in future profits. A drop in the share price would result in a drop in the P/E ratio.
A high P/E ratio, on the other hand, suggests that investors anticipate increased earnings in the future. Assume you are an investor looking into a firm that specializes in the manufacture of electric vehicles. Despite the fact that earnings are currently minimal, this area is rapidly expanding, and investors see promise in the firm. A P/E ratio like this could attract investors who trust in the company’s potential in the electric car sector. Although the profit has not yet been realized, a higher stock price would have resulted in an increase in P/E.
Of course, the P/E ratio should be evaluated with other financial indicators and aspects of the business. It is not the only thing to consider while making an investment choice. It is critical to undertake a thorough study in order to learn about the larger context and make smart investment decisions.
A high or low P/E ratio – what does it mean?
Consider benchmarks that assist you in determining the size of an asset. It is impossible to identify what is more or less and how to compare things without them.
To determine how “expensive” stocks are in the market, take a stock market index as a benchmark, such as the S&P 500, and then compute the P/E ratio for it. It is feasible to evaluate if a stock’s P/E ratio is high or low by comparing its path to that of the S&P 500 index.
You may also compare P/E to the average in a certain industry. For example, by comparing McDonald’s P/E to the average P/E for fast food firms, you can see how the price of McDonald’s shares compares to other companies in this industry.
If you have to choose between two stocks to invest in, understanding their P/E ratio will help you decide. You will learn which of the equities is more “expensive” in terms of P/E and what investors believe about these firms’ potential profitability.
What to do with negative P/E?
It should be noted that if the P/E ratio is negative, this may happen if the firm is losing money and its profits per share are decreasing. A long-term negative P/E ratio could signal the company’s financial issues, which should be checked.
Why does P/E matter?
Perhaps you believe that simply looking at the price of shares is sufficient to evaluate their “high cost.” However, this is not always useful, and in this instance, the P/E indicator comes in handy. The share price represents the value of one firm share, but it is also affected by the quantity of shares available. Assume that stocks are comparable to a slice of apple pie. To decide if a pie for $7 or a pie for $10 is better, you must first know the size of each slice.
The P/E ratio estimates the amount of a “piece of pie” by calculating the value of a stock for every dollar of earnings. This enables you to compare different firms’ earnings per dollar of stock value, independent of their overall size or number of shares.
Different approaches for calculating the P/E ratio
In our previous example, we estimated profits per share based on last year’s data for the last twelve months for Apple. However, because the P/E ratio indicates how investors see the company’s future, it is occasionally beneficial to compare the stock price to the predicted profits for the next twelve months. This is known as “forward profit”.
To estimate the predicted earnings, you may look at the company’s official profit estimates (not all firms disclose such information) or seek the advice of stock professionals. This gives you an insight into what the firm expects in the future and how investors could view its shares based on these predictions.