The Price Earnings ratio is one of the top tools for stock valuation because it makes a direct connection between share price and earnings. But context is everything and it’s important to work out the ratio over a number of years.
The price earnings ratio (P/E ratio) is a useful tool for investors because it tells how a company’s stock price stacks up against its earnings. It also indicates how optimistic – or pessimistic – the market feels about the firm’s future growth prospects.
Market players like the price earnings ratio because earnings are what matters most for corporate share health and this mechanism values the stock through profits.
First, some quick math.
We arrive at the company’s price earnings ratio by dividing the current price of the common stock by the earnings per share (EPS) from the past 12 months. The result allows us to compare one share with another.
For example, let’s say Sawtooth National Bank shares are trading at $60 and its EPS was $5. The price earnings ratio would be 12.
But let’s look at another firm in the financial sector. Suppose competitor Flywheel Financial has shares trading at $30 with an EPS of $2.50 and also has a P/E ratio of 12.
You might think that both stocks are equally valued. But here we get to an important aspect of using the price earnings ratio – it’s important that the ratio be worked out for other periods besides the most recent 12-month period, which is referred to as the trailing P/E.
For example, going back a few years, you might have found that Flywheel’s EPS was down from $3 the year before and $4 the year before that. This would indicate that Flywheel has some persistent problems in the market that management has failed to address. Maybe the company has warned it will miss its own earnings forecast.
That’s only one side of things. History is well and good and a company’s past performance is crucial in determining a stock price, but the market is forward looking. It’s also important to see where market professionals see a stock heading over the next year or so.
The price earnings ratio can therefore also be used as a tool to forecast where a stock is headed.
To calculate this forward P/E, you would divide the market price per share by anticipated earnings that have been forecast by analysts.
But remember, these are estimates and subject to the usual variables and potential mistakes that can happen with estimates.
That means the price earnings ratio is useful but only to a point. The P/E ratio is a handy tool for comparing companies in the same sector but you wouldn’t want to use them to compare companies in various industries.
An obvious example would be the comparison between a high-growth area like technology with a low-growth, stable sector such as utilities. The tech company may have a higher P/E, reflecting market optimism for the future, but that doesn’t mean its stock is necessarily a better buy than the utility.
Working out a price earnings ratio for a money-losing company is also problematic. Some would put it at zero and others would say a P/E ratio for an unprofitable company doesn’t exist.
So while this is an important tool to understand, P/E ratios should only be one consideration in the overall analysis around the worth of any one stock.
