Last Updated on 2019-12-22 by Admin
Another piece of fundamental analysis to help you assess the value of a share is a company’s price to earnings, or P/E ratio.
A P/E ratio is basically the amount investors are willing to pay for a share in a company, relative to its earnings.
Put another way, it shows how many years it would take for the company’s earnings to match the current price of its shares.
It is worked out by dividing the company’s current share price by its earnings per share.
Current share price ÷ earnings per share = P/E ratio
For example, a company whose shares are trading at $1 and has earnings per share of 10 cents has a PE ratio of 10.
100 (cents) ÷ 10 (cents) = 10
Essentially a P/E ratio reflects the earnings potential of a company in the eyes of investors.
At first glance, a high P/E ratio suggests that investors believe it has high growth potential, whereas a low P/E ratio would indicate that growth is expected to be slow or non-existent.
Historical PE ratios vary from sector to sector and over time. The P/E ratio of the broad Australian share market has for the most part fluctuated between 10 and 20, with a long-term average of around 15.
When share markets and the wider economy are doing well, investors tend to be more confident about the future earnings potential of companies, causing P/E ratios to rise.
The opposite is likely to occur when economic conditions or share markets are not doing so well.
If you are considering buying shares in a company it can be useful to compare its P/E ratio to that of the broader market and particularly other companies in the same sector.
A company with a P/E ratio above all others in its sector could be considered to be expensive and one with a much lower P/E ratio could be considered cheap. Having said that, a higher P/E ratio may be a sign of a company with superior growth prospects.
A company’s current P/E ratio should be considered in conjunction with its previous and forward (projected) P/E ratio and broader financial performance and outlook, as well as that of its peers and the wider market.
Different sectors tend to trade on very different levels of P/E ratios.
For example, slow growth industries like utilities and pharmaceuticals will typically carry low P/E ratios than faster growth industries.
Large, established companies that pay out a large portion of their earnings in dividends are also likely to have lower P/E ratios.
To find the Price-to-Earnings (P/E) ratio of a company, follow these steps:
The market price per share is the current price at which the company’s stock is trading in the market. You can find this price from various sources, such as:
For example, if a company’s stock is trading at $120 per share, that is the market price.
The EPS is a measure of a company’s profitability. It represents the portion of the company’s profit allocated to each outstanding share of common stock. There are two main types of EPS:
Typically, the Trailing EPS is used when calculating the P/E ratio, as it reflects the company’s actual earnings performance.
You can find the EPS in:
EPS is calculated as:
If a company reports Net Income of $10 million and has 5 million shares outstanding, the EPS would be:
Once you have the Market Price per Share and EPS, you can calculate the P/E ratio using this formula:
For example, if the market price per share is $120 and the EPS is $2, the P/E ratio would be:
So, the company’s P/E ratio would be 60, meaning investors are willing to pay 60 times the company’s earnings for each share of stock.
To assess whether a company’s P/E ratio is high or low, it’s useful to compare it to:
This can help determine if the stock is fairly priced, overvalued, or undervalued relative to similar companies.
Example:
Let’s say:
The P/E ratio would be:
This tells you that investors are willing to pay 60 times the company’s earnings for each share of stock. Depending on the industry and market conditions, this could indicate that the stock is highly valued due to growth expectations or other factors.
To find the P/E ratio of a company, you need to:
Understanding the P/E ratio helps evaluate the relative valuation of a company and aids in comparing investment opportunities.
$$\begin{aligned} Price\;to\;Earnings\;Ratio\;(P/E) &= \left[ Share\;Price\over Earnings\;Per\;Share\right]\end{aligned}$$
