PRICE TO EARNING RATIO

8/7/2019 PRICE TO EARNING RATIO

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PRICE TO EARNING RATIO

By: Surbhi Agarwal

Pallavi Tikoo


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What is P/E ratio

The P/E ratio (price-to-earnings ratio) of a stock (alsocalled its "P/E", or simply "multiple") is a measure of theprice paid for a share relative to the annual netincome or profit earned by the firm per share.

It is a financial ratio used for valuation: a higher P/E ratiomeans that investors are paying more for each unit of netincome, so the stock is more expensive compared to onewith lower P/E ratio.

The P/E ratio has units ofyears, which can be interpreted as

"number of years of earnings to pay back purchase price",ignoring the time value of money. In other words, P/E ratioshows current investor demand for a company share.


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Contd..

The reciprocal of the PE ratio is known as the earnings yield. Theearnings yield is an estimate of expected return to be earned fromholding the stock.

P/E Ratio = Price per share

Annual earnings per share

The price per share in the numerator is the market price of a singleshare of the stock. The earnings per share inthe denominator depends on the type of P/E:

"Trailing P/E" : Earnings per share is the net income of the companyfor the most recent 12 month period, divided by number of sharesoutstanding. Monthly earning data for individual companies are notavailable, so the previous four quarterly earnings reports are usedand earnings per share is updated quarterly.


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"Trailing P/E from continued operations": Instead of netincome, uses operating earnings which exclude

earnings from discontinued operations, extraordinaryitems (e.g. one-off windfalls and writedowns), oraccounting changes. Note, longer-term P/E data suchas Schiller's uses net earnings.

"Forward P/E: Instead of net income, uses estimated

net earnings over next 12 months. Estimates aretypically derived as the mean of a select group ofanalysts (note, selection criteria is rarely cited). Intimes of rapid economic dislocation, such estimatesbecome less relevant as "the situation changes" (e.g.

new economic data is published and/or the basis oftheir forecasts become obsolete) more quickly thananalysts adjust their forecasts.


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Uses of P/E Ratio

The P/E is more than a measure of a company's past

performance. It also takes into account market expectations

for a company's growth. Remember, stock prices reflect what

investors think a company will be worth. As a result, a better

way of interpreting the P/E ratio is as a reflection of the

market's optimism concerning a company's growth prospects.

If a company has a P/E higher than the market or industry

average, this means that the market is expecting big things

over the next few months or years. A company with a high P/Eratio will eventually have to live up to the high rating by

substantially increasing its earnings, or the stock price will

need to drop.


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It's difficult to determine whether a particular P/E is high or lowwithout taking into account two main factors:

1. Company growth rates - How fast has the company beengrowing in the past, and are these rates expected to increase, or atleast continue, in the future? Something isn't right if a company hasonly grown at 5% in the past and still has a stratospheric P/E. Ifprojected growth rates don't justify the P/E, then a stock might be

overpriced. In this situation, all you have to do is calculate the P/Eusing projected EPS.

2. Industry - It is only useful to compare companies if they are inthe same industry. For example, utilities typically have low multiplesbecause they are low growth, stable industries. In contrast, the

technology industry is characterized by phenomenal growth ratesand constant change. Comparing a tech company to a utility isuseless. You should only compare high-growth companies to othersin the same industry, or to the industry average.


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Problems with P/E Ratio Till now we have studied about the P/E ratio and how it is

calculated. But P/E analysis is only valid in certain circumstancesand it has its pitfalls. Some factors that can undermine theusefulness of the P/E ratio include:

Accounting : Earnings is an accounting figure that includes non-cashitems. Furthermore, the guidelines for determining earnings are

governed by accounting rules (Generally Accepted AccountingPrinciples (GAAP)) that change over time and are different in eachcountry. To complicate matters, EPS can be twisted, prodded andsqueezed into various numbers depending on how you do thebooks.

Inflation: In times of high inflation, inventory and depreciation costs

tend to be understated because the replacement costs of goodsand equipment rise with the general level of prices.


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Thus, P/E ratios tend to be lower during times of highinflation because the market sees earnings as

artificially distorted upwards. As with all ratios, it'smore valuable to look at the P/E over time in order todetermine the trend. Inflation makes this difficult, aspast information is less useful today.

Many Interpretations: A low P/E ratio does not

necessarily mean that a company is undervalued.Rather, it could mean that the market believes thecompany is headed for trouble in the near future.Stocks that go down usually do so for a reason. It maybe that a company has warned that earnings will come

in lower than expected. This wouldn't be reflected in atrailing P/E ratio until earnings are actually released,during which time the company might lookundervalued.


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Conclusion

While concluding we can say that it can be useful tocompare the P/E of one company to another in the sameindustry, to the market in general, or to the company's ownhistorical P/E ratios.

Some points to remember: The P/E ratio is the current stock price of a company

divided by its earnings per share (EPS).

Variations exist using trailing EPS, forward EPS, or anaverage of the two.

Historically, the average P/E ratio in the market has beenaround 15-25.

Theoretically, a stock's P/E tells us how much investors arewilling to pay per dollar of earnings.


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A better interpretation of the P/E ratio is to see it as areflection of the market's optimism concerning a firm's

growth prospects. The P/E ratio is a much better indicator of a stock's value

than the market price alone.

In general, it's difficult to say whether a particular P/E ishigh or low without taking into account growth rates and

the industry. Changes in accounting rules as well as differing EPS

calculations can make analysis difficult.

P/E ratios are generally lower during times of high inflation.

There are many explanations as to why a company has a

low P/E. Don't base any buy or sell decision on the multiple alone.

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PRICE TO EARNING RATIO