Price to earnings (P/E) ratio is one of the most important metrics in valuing a business or a stock. After all, the goal of any business is to make as much money as possible. This article will discuss how to calculate the ratio, high and low ratios, P/E ratio and dividends, and basically everything about this ratio. P/E ratio measures how much profitable a business is, relative to the current price of a stock.
It is calculated by dividing the current stock price to its Earnings per Share (EPS). Thus, P/E ratio is basically how much an investor has to pay for every $1 of earnings in a year.
It is also called Earnings Multiple.
An earnings multiple of 20 means an investor has to pay $20 for every $1 of company’s earnings.
There are 2 kinds of P/E ratio: trailing and forward. Trailing P/E takes the last 12 months of earnings, while forward takes into account the earnings in next 12 months. In this article, we’ll focus more on trailing PE as it is a fixed number, while forward PE varies since it is mostly estimated by analysts or the company itself.
Formula
P/E Ratio = Earnings per Share / Stock Price
or
P/E Ratio = Net Income of a Company / Market Cap
Either Formula will give you the exact same results.
Importance
Learning about P/E ratio could give you some idea on how much a stock is valued. When you’re buying any clothes or foods, you don’t want it to be overpriced. It has to be fairly valued, if not cheaper. P/E ratio exactly does that, it could provide you some idea how much you’re paying for a share of a company. An expensive stock (high P/E) must have some growth potential ahead of it, or some reason that will justify its price. Also, its the most straightforward metrics of a company. If earnings is constant in the future, P/E is the number of years of earnings to pay back the purchase price.
Example
Company A reported a net income on Year 1 of $200 million and has a market cap of $4 billion. Also, it currently trades at $100 per share with 40 million shares outstanding, resulting to an EPS of $5. What is its earnings multiple?
Method 1
P/E = EPS / Stock Price
= $100 / $5
= 20
Method 2
P/E = Net Income / Market Capitalization
= $200 million / $4 billion
= 20
Notice that both formula does result in the same number.
Real-Life Example – Apple Stock
On January 2, 2020, Apple stock closed the day trading at $300.35. It reported a total earnings per share (EPS) of $11.89 in the last 12 months. What is its earnings multiple?
P/E = Share Price / EPS
= $300.35 / $11.89
= 25.26
This means that if you bought the stock at $300.35 per share on that day, you’re paying $25.36 for every $1 of earnings.
Applying P/E Ratio in Valuing a Stock
A lower P/E ratio is achieved by two things: lower stock price or higher earnings. That’s why most people prefer to invest in stocks with lower ratio. Higher stock price leads to a higher earnings multiple, and lower earnings means higher earnings multiple. That’s why P/E ratio is an important metric, as it values the stock directly to its earnings.
P/E ratio is mostly useful when it compared to stocks in the same industry. Technology stocks usually has a high multiple, while commodities like established fast foods chains has lower P/E. Another useful comparison is to compare it with the same revenue growth and earnings growth. A stock that grows 50% of its income is generally more expensive than a stock that grows 2%.
As with any stock metrics, P/E ratio does not necessarily tells a stock undervalued or overvalued. Instead, earnings multiple is one of the factors to use to judge if a stock is overvalued or undervalued. Also, its important to know the reason why a stock trades at a high or low earnings multiple.
Does High P/E stocks Means a Bad investment?
Well, not really. Some businesses is growing very fast. Some stocks grows revenue and earnings by at least 50% every year. Since the business is projected to grow, investors are willing to pay more. Some businesses even lost money, thus they don’t have an earnings multiple. High P/E stocks must be justified, as they are considered more expensive. They must be growing faster, or have some kind of advantage compared to other companies. Otherwise, there’s no point in paying higher multiple if they have the same revenue growth.
P/E can go as high as 500 or even 2000. That high of ratio is mostly irrelevant when deciding picking stocks. The positive thing is that it makes money, which means its not losing money. In these cases, P/S ratio might give you a better idea on value of a stock. High earnings ratio can be justified if earnings are projected to grow by a lot in the next years.
Risks and Rewards of High P/E
Stocks with high ratio is usually more volatile, which means it is more likely to outperform the market, or under perform the market in any day. It could go up or down by 10% in a day.
The best stocks and worst stocks in a year usually has a high ratio or no ratio at all (negative earnings). High multiple stocks could deliver 500% returns in a 3 year period. At the same time, it could go down by 70% in a 3 year period. That’s why these stocks are popular as it could deliver impressive returns or nasty returns. In the end, just be ready for price fluctuations.
When a stock go down by 30% or more, it may be worth it to take a look and evaluate if its a great company and fairly valued. After all, the purpose of investing in to buy low and sell high.
Average P/E Ratio of S&P 500
In the last 100 years, the average P/E ratio of S&P 500 is 15.77. On December 31, 2019, the market closed trading with ratio of 24.30. P/E of higher that 24.30 at that time is considered higher than average while lower that is considered lower than average. But it depends on industry, a ratio of 15 could be high in a certain industry with no growth. While a ratio of 30 could be low in another industry. The average ratio could be used to know where the overall value of the stocks currently is.
Is it justified? Many people argues that its too high and thus, stocks is expensive. While others argues that it is justified since earnings will eventually catch up, thus P/E will go down due to higher earnings. For context, the average ratio is above 20 from 2015 to 2019, and there is no recession in that time period.
P/E ratio and Dividend Investing
One of the secret uses of P/E ratio is that it can tell if dividends of a stock is justified. Some stocks have dividends of 8% which is really high, and is usually a red flag. But with P/E, we could verify if dividends were justified.
Dividends are basically the amount of money that some companies pays to the investors as an incentive for holding their stock. But that dividend money did not come from thin air, its actually withdrawn from the cash balance of a company. After paying dividends, a business will have less cash than before paying the dividends. Thus, we have to make sure that the company earns more profit than it pays dividend to justify its dividend payment.
Here is a simple formula:
1 divided by P/E Ratio X 100% should be greater than the dividend yield
Example – Apple Stock – Is Dividend Justified?
Apple stock closed the year at December 31, 2019, trading at 24.78 P/E. On the other hand, its dividend yield is 1.02%.
1 divided by P/E ratio X 100%
= 1 / 24.78
= 4.03% is greater than 1.02%
This means that Apple’s dividends is justified. Apple is earning enough to pay its shareholders. In fact, Apple could pay up to 4.02% of dividends, if they decide to pay every earnings to shareholders. If they pay more than 4.02%, they’re financial position could be worse compared to the year prior. Their dividend yield is enough to have more cash invested for growth and they are in position to increase their dividends in the future.
Limitations of P/E Ratio
Some businesses losses money, making earnings to be negative. In that case, there is no earnings ratio. Instead, Price to Sales Ratio might be the better value estimator for those kinds of companies. Many companies today in the US stock market, especially IPOs (Initial Public Offering) loses money, with the promise that their revenue grows massively.
Moreover, it does not take into account the condition of the balance sheet of a company. A company may have a lot of debt, but this ratio does not take into account those debt. It only considers the current price and the revenue it earned.
Another limitation to earnings ratio is that there might be unexpected costs that could affect earnings greatly from year to year. An example of this is Facebook on 2019, they are fined $5 billion dollars for privacy violations. Thus, 2019 earnings will decrease by $5 billion dollars, while on 2020, they don’t have to pay that money. That could cause 2019 earnings multiple to be larger since there is a one-time reduction in net income.
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