The price-earnings ratio, or the P/E multiple is one of the most widely used valuation measures, it helps in assessing the market price of a stock relative to its earnings. P/E ratio is more of a comparable or relative valuation measure, which when compared with a stock’s historical P/E or the P/Es of its peers, helps in analyzing whether a stock is overvalued or undervalued at the current levels.
For example, if a company was currently trading at a P/E ratio of 15, it would indicate that investors are currently willing to pay $15 for every $1 in earnings.
How is the P/E Ratio Calculated?
P/E multiple is the ratio of the current stock price of a company divided by its EPS or earnings per share. The formula for the P/E ratio depends on whether we are using the Trailing P/E ratio or the Forward P/E ratio.
The trailing P/E ratio is based on a company’s historical earnings. It can be computed by dividing the stock price by EPS for the trailing 12 months (or TTM), which is basically EPS for the most recent four quarters.
Analysts generally prefer excluding any one-time or non-recurring items from the computation of EPS.
Forward P/E is based on estimated earnings for the next four quarters.
Let us take an example. PepsiCo’s stock price was $143.42 as of Nov. 20. Its EPS (TTM) stands at $5.05. So its Trailing P/E ratio =$143.42/$5.05 = 28.4.
Why is the P/E Ratio Important?
P/E ratio is an important tool for making investment decisions. It helps the investor in comparing a stock with its own historical P/E or with P/Es of competitors or even the broader sector/market average. That helps the investor understand whether the stock is overvalued or undervalued, and to invest accordingly.
Analyzing a company’s P/E ratio is vital for making an informed investment decision. Generally, a stock with a higher P/E compared to its peer group is considered overvalued and the one with a lower P/E is considered undervalued. However, one should be cautious before making such a conclusion as explained below.
For example, technology companies generally have a very high average P/E ratio of 17, while public utility companies tend to have a much lower P/E ratio, of 3. Damodaran (a finance professor) maintains a complete list of the average P/E ratio for over 97 sectors, plus a downloadable spreadsheet file containing records of over 42,000 companies and the sector/industry to which they belong.
However, even within the specific sector, this indicator can have huge differences. Alphabet Inc (NASDAQ: GOOGL) currently trades at a P/E ratio of above 30. From this, one can derive that investors are still expecting a very sharp growth for Alphabet over the next several years, in comparison to the large-cap tech stocks in its class. Growth companies generally have higher P/E ratios. In contrast, one of Alphabet’s main competitors, Apple, has a much lower P/E ratio of just 10. This demonstrates that investors expect much less growth in scale from Apple than from Google.
In the Smart Portfolio, your portfolio’s P/E ratio is calculated by evaluating the actual P/E of each asset, together with its relative weight of your portfolio total. A growth-oriented portfolio will categorically surpass the average TipRanks portfolio P/E. A value-oriented portfolio will most likely have a lower P/E score than the average. Depending on your financial goals, you can adjust the stocks, funds, and ETFs in your portfolio and monitor your growth/value orientation via your portfolio’s average P/E ratio.
What does a High P/E Ratio Indicate?
A high P/E ratio does not necessarily mean that a stock is overvalued compared to its peers or its own historical valuation. A stock’s higher P/E than its peers could indicate that investors are willing to pay a higher price for the stock because of better earnings growth expectations from the company compared to the peer group.
Let us consider an example. The TipRanks Stock Comparison tool indicates that the PE ratio of Coca-Cola stands at 27.7, while that of PepsiCo and Monster Beverage are 28.4 and 37.5, respectively. Here, we cannot conclude that Monster Beverage is overvalued because it has a higher P/E than peers. Monster Beverage’s premium valuation over that of its larger peers reflects its higher earnings growth prospects, backed by strong demand in the energy drinks market.
Also, generally, it is better to compare stocks within a sector or industry as several companies in sectors like Tech usually trade at a higher P/E than companies in the consumer staples sector.
What does a Low P/E Ratio Indicate?
Similarly, a lower P/E ratio than the industry average does not essentially mean that a stock is undervalued or is a value stock and is a good bargain currently. It could also imply that the earnings growth prospects of the company are not attractive enough to justify a higher valuation multiple.
PE Ratio Signal
The PE ratio signal ranks stock according to their price-to-earnings ratio. This allows investors to identify and purchase stocks that are ranked with the lowest positive PE ratio and (if applicable) short-sell stocks that are ranked with the lowest negative PE ratio.
Each day we calculate the PE ratio by taking the last available closing price and dividing it by the company’s diluted EPS (earning per share) during the last four quarters. If the sum of the last 4 quarters’ EPS is exactly zero, then the PE ratio signal is NULL.
Later stocks are ranked with a score of 10 to 0, with 10 having the lowest positive PE ratio to 0 having the lowest negative PE ratio.
Conclusion
The P/E ratio is a useful tool for stock analysis and indicates the price that the market is willing to pay for a stock based on its earnings. A stock with a high P/E could imply that it is a growth stock with stronger prospects than its peers and thus warrants a higher valuation multiple. In contrast, it could also imply that the stock is possibly overvalued. Meanwhile, a stock with a low P/E ratio could imply that it is undervalued and is a good ‘buy’, or on the other hand, it could mean that the market has low expectations for future growth. Hence, comparing the P/E ratio with peers and assessing the earnings growth rate is vital before making any investment decision.
PE is calculated daily for over 6,000 stocks in the historical database. TipRanks calculates PE as of January 2011 to the present day.