The price-to-earnings ratio or P/E ratio is a tool for assessing a company’s valuation. This straightforward, quantifiable metric allows you to compare companies operating across similar lines of business, showing their potential for growth and success.
What is the P/E Ratio?
The P/E ratio is calculated by dividing a stock’s current market price by its earnings per share (EPS). Diluted EPS is often used for this calculation as it incorporates all the securities that could potentially dilute earnings per share, providing a more conservative view of a company’s profitability.
A significantly higher or lower P/E ratio can signal various market perceptions and expectations, warranting further investigation. For example, a high P/E ratio may indicate that a stock is overvalued or that significant growth is anticipated. Meanwhile, a low P/E ratio could suggest you’re getting a bargain or reflect pessimism about the company’s future. Warren Buffett always said investing aims to acquire great companies at fair prices rather than settle for mediocre investments at attractive prices. High P/E ratios don’t necessarily preclude a good investment if the company’s future is bright.
The complexities don’t end there. Companies can manipulate earnings and one-off events, skew the ratio, and paint a misleading picture. Growth expectations and industry comparisons further complicate the analysis, which is why the P/E ratio is a good place to start when conducting a deeper analysis.
Variants of the P/E Ratio
The price-to-earnings, or P/E, ratio is simple to calculate. However, the earnings component alone can be calculated in different ways. There are two main approaches to calculating the P/E ratio itself, and each approach tells you different things about a stock.
Trailing Twelve Month (TTM) Earnings
One way to calculate the P/E ratio is to use a company’s earnings over the past 12 months. This is called the trailing P/E ratio or trailing twelve-month earnings (TTM). Factoring in past earnings has the benefit of using actual, reported data, and this approach is widely used in evaluating companies. Many financial websites, such as Google Finance and Yahoo! Finance, use the trailing P/E ratio.
Forward Earnings
The price-to-earnings ratio can also be calculated using an estimate of a company’s future earnings. While the forward P/E ratio, as it’s called, doesn’t benefit from reported data, it has the benefit of using the best available information on how the market expects a company to perform over the coming year.
The Shiller P/E Ratio
You might wonder, “Can I use the P/E ratio when looking at the market as a whole?” If so, the CAPE Shiller P/E ratio emerges as a useful alternative measure. The CAPE ratio, which stands for cyclically adjusted price-to-earnings ratio, evaluates broad equity indices’ average earnings per share (EPS) over a decade. Applying averages over 10 years aims to even out profit variances across different phases of an economic cycle.
Understanding the P/E ratio and its variants can help you make more informed investment decisions. While it’s not the only metric you should consider, it provides a valuable starting point for evaluating a company’s financial health and prospects.
