Valuation Metrics: Price-Earnings Ratio (P/E)
Understanding Price-Earnings Ratio (P/E) - A Comprehensive Guide
1. Price-Earnings Ratio (P/E Ratio)
The Price-Earnings Ratio (P/E Ratio) measures the valuation of a company's stock relative to its earnings. It is calculated by dividing the market price per share by the earnings per share (EPS).
Formula:
P/E Ratio = Market Price per Share / Earnings per Share
The market price per share represents the current trading price of a single share of the company's stock. Earnings per Share (EPS) is calculated by dividing the company's net income by the weighted average number of outstanding shares.
2. Forward Earnings Estimate
Forward earnings estimates are projections of a company's future earnings. Analysts use various methods and factors to estimate the earnings expected in the upcoming period, typically the next fiscal year.
The forward earnings estimate is crucial in determining the future growth potential of a company. It considers factors such as industry trends, macroeconomic conditions, company-specific initiatives, and competitive dynamics to forecast future earnings.
3. Trailing Estimate
The trailing estimate, also known as the trailing P/E (Price-Earnings) ratio, compares the market price per share to the company's earnings per share over the previous period, usually the last twelve months (TTM). It provides an overview of the company's historical performance.
Formula:
Trailing P/E Ratio = Market Price per Share / Earnings per Share (TTM)
The trailing P/E ratio is commonly used to assess the relative value of a company's stock based on its recent earnings performance.
4. Reasons for Differences in P/E Ratios
P/E ratios can vary across companies due to several factors:
- Industry Differences: Companies in different industries may have varying growth prospects, risk profiles, and profitability levels. Industries with higher growth expectations tend to command higher P/E ratios.
- Company-specific Factors: Variations in a company's financial performance, market position, competitive advantages, and growth potential can influence its P/E ratio.
- Investor Sentiment: Market participants' perceptions, expectations, and sentiment towards a particular company or industry can impact P/E ratios.
5. Relating Today's Price to Next Period's Earnings
To relate the current market price to next period's earnings, we use the forward P/E ratio. It compares the market price per share to the projected earnings per share for the upcoming period.
Formula:
Forward P/E Ratio = Market Price per Share / Forward Earnings per Share
The forward P/E ratio provides insight into investors' expectations regarding the company's future earnings growth. A higher forward P/E ratio implies higher anticipated earnings growth.
6. Problems with P/E Ratios
Selection of Comparison Firms
When comparing P/E ratios, it is crucial to select comparable firms within the same industry or sector. Comparing companies from different industries can lead to distorted interpretations due to variations in growth rates, risk profiles, and profitability levels.
(Non)-Aggregation of Comparables
To derive a representative industry-level P/E ratio, it is common to aggregate the P/E ratios of multiple companies within an industry. Proper weighting based on factors such as market capitalization should be applied to avoid skewing the industry-level P/E ratio.
The 1/X Domain Problem
P/E ratios encounter issues when earnings are negative or close to zero. This problem arises because dividing a positive stock price by a small or negative earnings value produces misleading results. In such cases, alternative valuation metrics, such as Price/Sales (P/S) ratio, may be more appropriate.
7. TTM Adjustments
Trailing Twelve Months (TTM) adjustments are applied to the earnings per share calculation to accurately reflect the company's performance over the past twelve months. TTM adjustments are necessary when significant events such as acquisitions, divestitures, or one-time gains or losses occur.
By adjusting the earnings to account for these events, a more accurate trailing P/E ratio can be obtained, providing a better measure of the company's overall performance.
This article takes inspiration from a lesson found in FINN 3103 at the University of Arkansas.