What Does Price-Earnings Ratio - P/E Ratio Mean?

A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:

For example, if a company is currently trading at $43 a share and earnings over the last 12
months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the
estimates of earnings expected in the next four quarters (projected or forward P/E). A third
variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

Also sometimes known as "price multiple" or "earnings multiple".

Investopedia explains Price-Earnings Ratio - P/E Ratio

In general, a high P/E suggests that investors are expecting higher earnings growth in the future
compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story
by itself. It's usually more useful to compare the P/E ratios of one company to other companies
in the same industry, to the market in general or against the company's own historical P/E. It
would not be useful for investors using the P/E ratio as a basis for their investment to compare
the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has
much different growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are
willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of
20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to
avoid basing a decision on this measure alone. The denominator (earnings) is based on an
accounting measure of earnings that is susceptible to forms of manipulation, making the quality
of the P/E only as good as the quality of the underlying earnings number.
Interpreting the Price/Earnings Ratio
[Part 1: Interpreting the Price/Earnings Ratio - Why
Connect Price to Earnings?]
by Jenny Luesby

People who own shares want to know one thing above all -
which way is the share price headed? Without reaching for the
crystal ball, there is a financial ratio that can give us some Related Resources

clues on whether shares are cheap or expensive. • Glossary of Economics Terms

Most business journalists fight shy of this ratio, and so do the

majority of investors. It's hard to understand why. The p/e ratios is simple to calculate and
probably the most consistent red flag to excessive optimism and over-investment. It also
serves, regularly, as a marker of business problems and opportunities. So, if you can bear
to divide one number by another and interpret the results, our advice is: it's worth the
effort!

Calculating the Ratio

The starting point for the P/E ratio is the share price. This is the P.

The P/E takes this share price and divides it by earnings per share (which is the company's
entire net profit, or earnings, divided by the number of shares in issue). This is the E.

Together these two numbers relate the market's valuation of a company's shares to the
wealth the company is actually creating.

Why connect price to earnings?

Any share price is built on expectations of a company's future performance. Some of these
expectations will be based on fundamentals - such as the company's recent performance, its
new product lines, and the prospects for its sector. The rest will reflect prevailing moods,
fashions and sentiment.

By relating share prices to actual profits, the P/E ratio highlights the connection between the
price and recent company performance. If prices get higher and profits get higher, the ratio
stays the same. The ratio only moves as price and profits become disconnected.

For this reason, when the ratio is higher or lower than normal we know that recent profit
levels are no longer the main factor in pricing. This might be because change is afoot -
investors expect a much better or worse performance next year - or because sentiment is
now the dominant factor. Either situation is news worthy.

How it works in practice

In the summer of 2001, the average P/E ratio across all shares listed on the London Stock
Exchange was running at around 21. Yet the average P/E for Telecom was 67. Immediately
we can see that share prices are far higher for Telecom companies, compared to profit
levels, than they are for companies generally.

If we look for fundamental reasons for this, we can see that the sector has been hard hit
recently by licence costs and the global economic slowdown. So current profits may be
unusually low. Investors obviously "feel" certain of a better performance in future. Indeed, a
P/E of 67 suggests expectations of huge forthcoming profit hikes. But how justified is this?
And are we now looking at shares that are appropriately valued on the basis of future profit
expectations alone?

Testing for future profits

Generally, we test for the importance of future profits to the current P/E by building a
prospective P/E ratio. This takes the current share price (P) and divides it by forecast
earnings per share (E) for next year, and even the following year. We get these earnings
forecasts from stockbrokers' analysts.

If next year's profits are on course to be significantly higher than this year's, the
prospective P/E ratio will be lower than the current P/E ratio. For companies and sectors in
take-off or rapid growth this often turns out to be the case. The abnormally high current P/E
ratio simply reflects future profit levels - they have already been written in to the share
price.

However, in the case of telecom, shares still look over-valued

when we take into account forecasts for future growth and
profits.

Interpreting the Price/Earnings Ratio

[Part 2: Interpreting the Price/Earnings Ratio - Could it
be Irrational Exuberance?]

This mismatch between outlook and share price is, in fact, Related Resources
typical in a sector whose character has changed rather • Glossary of Economics Terms
suddenly.

In the recent past, telecom was a rapidly expanding and

technologically advanced sector benefiting from premium pricing for its products. The first
thing to change was the premium pricing, as market saturation pushed telecom services
into aggressive price-cutting.

This continued even with the next generation technology, WAP, which failed to trigger
substantial new business. Then came massive new costs - funded through heavy debts - as
licences were auctioned.

Together, these changes made for a sector of a whole other nature than five years earlier.
And that was before the downturn! Currently, telecom is a saturated market with virtually
no technological differentiation, too many suppliers and too much debt.
Unfortunately, when an entire sector pulls off a change in character as swift as this,
investors are sometimes slow to appreciate the underlying nature of the shift. Expectations
of a recovery to the golden days can linger long after the factors that made for the initial
heyday have disappeared.

So, we end up with a sector with huge sentiment still built into pricing. Make up you own
mind whether this will be:

• sustained forever,
• eventually supported by an improvement in the fundamentals, or
• ultimately corrected out of the share price.

The P/E as a red flag

In fact, we have repeatedly seen this kind of red flag over fashionable sectors: perhaps
most recently in 1998/1999 over the Internet industry. The surprising thing is that we have
not yet fully absorbed its significance.

We have certainly seen it enough times. Thirty years ago, smart investors were buying only
into the so-called Nifty Fifty. This elite club included companies such as IBM and Coca-Cola,
which in the eyes of many could do no wrong. However, once the P/E ratios on these
companies had moved into the 60 to 90 range, the party was over. Even these companies
couldn't deliver the profit growth necessary to support share prices at this kind of multiple.
The Nifty Fifty subsequently produced way below average returns for close to the next
decade.

Moreover, on every single occasion where the P/E ratio for the entire market (not just one
sector) has risen substantially above 25 there has subsequently been a marked correction in
the market (a sharp fall in share prices).

The P/E behaving normally

Of course, to spice things up, a high P/E can also mean the opposite of trouble - it may just
be the marker of a true growth industry.

Before you can spot red flags, you need to know what is normal for the P/E. For instance,
each sectors' average P/E reflects the speed of expansion in that industry, how cyclical it is -
industries that traditionally move from boom to bust every 6 to 10 years tend to have
rather low P/Es - and its rate of technical renewal.

Average P/Es also shift depending on the position in the economic cycle. Construction
company shares will be far more highly valued as we enter an upturn than they are with a
slow-down approaching.

To find P/E ratios for whole markets and different sectors check tables such as the Actuaries
Share indices in the FT, or look for an extra line under each sector in the straight share
price statistics. For prospective P/Es for entire sectors and markets we again go to the
brokers' analysts.

It's also worthwhile watching for the highest or lowest individual P/Es within each sector.
If a P/E or prospective P/E is lower than the norm for a sector, we say the share is at a
discount - it's relatively cheap. Conversely, when an individual P/E is higher than the norm,
we say the share is at a premium, that is, relatively expensive.

But, in fact, the vital element in determining whether this share is truly a bargain are the
reasons for the current valuation ... and their validity.

Prices beyond reason

On its own, each P/E ratio is meaningless. The P/E points us to optimism or pessimism,
which we must then find the reasons for. In doing this, we reach vital information for our
business readers.

For example, a massively high P/E is sometimes the result of a rumoured take-over. Or it
may reflect an industry in tatters, where the share price is yet being supported by small
shareholders reluctant to face reality - retaining their holdings in the hope of better times.

It may equally reflect confidence in a new product that's set to be a blockbuster!

Whatever the story behind a variation from a normal share valuation, investors should know
about it.

Above all, the underlying reasons for current levels of optimism (or pessimism) are critical
in determining whether such valuations are likely to persist.

So, remember, no one P/E ratio has a fixed meaning (good or bad). There is no cut-off for
what is high or low. There is, however, normal and abnormal. So, get familiar with the
normal. Then you can use the abnormal to get straight to the places where share prices are
most definitely moving out of step.

What Does Earnings Per Share - EPS Mean?

The portion of a company's profit allocated to each outstanding share of common stock. Earnings
per share serves as an indicator of a company's profitability.

Calculated as:

When calculating, it is more accurate to use a weighted average number of shares outstanding
over the reporting term, because the number of shares outstanding can change over time.
However, data sources sometimes simplify the calculation by using the number of shares
outstanding at the end of the period.
Diluted EPS expands on basic EPS by including the shares of convertibles or warrants
outstanding in the outstanding shares number.

Investopedia explains Earnings Per Share - EPS

Earnings per share is generally considered to be the single most important variable in
determining a share's price. It is also a major component used to calculate the price-to-earnings
valuation ratio.

For example, assume that a company has a net income of $25 million. If the company pays out
$1 million in preferred dividends and has 10 million shares for half of the year and 15 million
shares for the other half, the EPS would be $1.92 (24/12.5). First, the $1 million is deducted from
the net income to get $24 million, then a weighted average is taken to find the number of shares
outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).

An important aspect of EPS that's often ignored is the capital that is required to generate the
earnings (net income) in the calculation. Two companies could generate the same EPS number,
but one could do so with less equity (investment) - that company would be more efficient at
using its capital to generate income and, all other things being equal, would be a "better"
company. Investors also need to be aware of earnings manipulation that will affect the quality of
the earnings number. It is important not to rely on any one financial measure, but to use it in
conjunction with statement analysis and other measures.