If you have some know-how about the stock market, you must have heard about the term “Price-to-Earnings (P/E ratio).” It is one of the most popular metrics to estimate the valuation of a company’s shares and its future prospects.
In this article, we have covered what exactly is P/E ratio, its significance, and how can it be used for evaluating stocks.
What is Price-to-Earnings (P/E) ratio?
Price-to-Earnings ratio defines the relationship between a company’s share price and its earnings per share (EPS). This valuation measure actually reflects the investors’ sentiments towards a company compared to its actual standing. To further simplify, the “P” of this ratio indicates how the general public is feeling about that firm in the form of stock’s price and “E” denotes how good the company is performing in reality in the form of EPS.
It can be simply calculated by dividing the share price by the company’s net profit per share (EPS). For instance, suppose a company has earnings of $50 million and 5 million shares outstanding. This translates to an EPS of 10. If the current stock price is $80, the P/E ratio would be calculated as follows: 80/10 = 8.
It means that this stock is trading at a multiple of 8 times the company’s actual earnings or investors are willing to pay an 8 times higher price than its earnings per issued share.
Understanding the P/E ratio
The P/E ratio helps investors understand if a stock is fairly valued or overpriced. Moreover, this metric works best as a “comparison tool” as examining it in isolation may not provide enough information to understand the company’s situation and performance.
Also, when comparing the P/E ratios of different stocks, it’s crucial to consider the context in which the ratios are being used.
For instance, comparing the P/E ratios of two companies in the same industry can be useful in determining which company is overvalued or undervalued relative to its peers. In contrast, comparing the P/E ratios of two companies in different sectors may not be as useful due to differences in circumstances and earnings or growth potential.
It is also important to consider the stage of a company’s lifecycle, as a younger, growing startup may have a higher P/E ratio than a mature company with a stable earnings history.
To better understand the P/E ratio, let’s consider a comparison between two companies in the same industry. Suppose, Company A has a share price of $150 and a P/E ratio of 20, while Company B has a share price of $100 and a P/E ratio of 25. This means that investors in Company A are paying $20 for every $1 of the company’s earnings, while investors in Company B are paying $25 for every $1 of the company’s earnings. Despite Company A having higher share price, its P/E ratio is lower than that of Company B.
This situation suggests that investors may be more optimistic about the earnings growth potential of Company B and are therefore willing to pay more for its stock. However, it’s important to note that this may not always be the case, and we’ll explore the different possibilities of high and low P/E ratios in the next section.
Assessing stocks from the P/E ratio
While there is no one-size-fits-all P/E ratio that is good or bad, here is what high and low ratios can probably indicate.
What does a High P/E ratio indicate?
A high price-to-earnings ratio can mean two things:
1. Expectations of higher future earnings – A hallmark of “growth stocks”
A notably high P/E ratio can signify that investors are positive about a company’s future earnings, expecting them to be much higher in the coming period than at the present levels. This sentiment is a characteristic of growth stocks where investors are willing to pay more for a company’s current earnings because they anticipate that its future earnings will increase remarkably.
2. Maybe over-valued
A very high P/E ratio of a stock compared to other similar companies or its own previous ratio may indicate that the stock is “overvalued.” The high P/E ratio of overvalued stocks stems from a broader optimism in the investors’ community instead of solid growth prospects. It can also be a result of declining earnings; if you look at the Price-to-earnings ratio’s mathematical formula, it suggests that the P/E ratio will surge if the EPS falls provided the stock price remains the same.
So how to determine if a stock is overvalued due to market hype or a growth stock? Aren’t growth stocks also just overvalued entities? The fact is that the higher valuation of growth stocks is somewhat justified as they accommodate a solid rationale for investors expecting higher future returns. Hence, investors need to delve deeper for understanding whether the high P/E ratio is due to a prevailing craze, falling earnings, or solid fundamentals.
What does a low P/E ratio indicate?
A low P/E ratio actually indicates two scenarios:
1. Undervalued compared to the actual stats – a hallmark of “value stocks”
A low P/E ratio may be a sign that a stock is undervalued, as it suggests that the share price is lower than the company’s intrinsic value or earnings statistics. From a technological perspective, this situation (a low PE ratio) can materialize if a company’s earnings climb while the stock’s price remains stationary.
Consequently, low P/E ratios provide value investors an opportunity to buy stocks with an expectation that the stock price will eventually increase to match the company’s true earnings.
Learn more about growth and value stocks: Growth Stocks vs Value Stocks: A Longstanding Debate
2. Due to the actual financial difficulties of the company
A low P/E ratio can also be a sign of actual financial trouble and the low growth potential of a company. Hence, a stock may be selling at a low P/E ratio because investors are not hopeful regarding the future earnings of that company due to real statistics.
Closing thoughts
P/E ratios can be a useful tool for comparing the relative valuation of different stocks, but it is important to consider the context, underlying reasons, and other factors that may influence the ratio. Moreover, while this metric cannot offer much on its own, it can be a great help if combined with other stock analysis techniques.
