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The P/E ratio of a stock (also called its "earnings multiple", or simply "multiple", "P/E", or "PE") is used to measure how cheap or expensive its share prices is. The lower the P/E, the less you have to pay for the stock, relative to what you can expect to earn from it. It is a valuation ratio included in other financial ratios. The price per share (numerator) is the market price of a single share of the stock. The earnings per share (denominator) is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. The EPS used can also be the "diluted EPS" or the "comprehensive EPS" For example, if stock A is trading at $24 and the Earnings per share for the most recent 12 month period is $3, then the P/E ratio is 24/3=8. Stock A said to have a P/E of 8 (or a multiple of 8). Put another way, you are paying $8 for every one dollar of earnings. It is probably the single most consistent red flag to excessive optimism and over-investment. It also serves, regularly, as a marker of business problems and opportunities. By relating price and earnings per share for a company, one can analyze the market's valuation of a company's shares relative to the wealth the company is actually creating. One reason to calculate P/Es is for investors to compare the value of stocks, one stock with another. If one stock has a P/E twice that of another stock, it is probably a less attractive investment. But comparisons between industries, between countries, and between time periods may be dangerous. To have faith in a comparison of P/E ratios, one should compare comparable stocks. Determining share prices Share prices in a publicly traded company are determined by market supply and demand, and thus depend upon the expectations of buyers and sellers. Among these are: By dividing the price of one share in a company by the profits earned by the company per share, you arrive at the P/E ratio. If earnings move up in line with share prices (or vice versa) the ratio stays the same. But if stock prices gain in value and earnings remain the same or go down, the P/E rises. For example, if a stock price was $70 per share and it got $2 in earnings, the P/E is 35, historically high. The price used to calculate a P/E ratio is usually the most recent price. The earnings figure used is the most recently available, but this figure is often a year old and does not necessarily reflect the current position of the company. Many times, you will hear this referred to as a trailing P/E, because it involves taking earnings from the last four quarters. It is possible, however, to use the earnings estimate for the next four quarters. When doing so, the ratio is referred to as a projected or forward P/E. Interpretation The average U.S. equity P/E ratio from 1900 to 2005 is 14 (or 16, depending on whether the geometric mean or the arithmetic mean is used to average), meaning it takes about 14 years for a company you purchase to earn back your full purchase price for you. Normally, stocks with high earning growth are traded at higher P/E values. Say, stock A may earn $6 per share the next year. Then the future P/E ratio is $24/6 = 4. So, you are paying $4 for every one dollar of earnings, which makes the stock more attractive than it was the previous year. Various interpretations of a particular P/E ratio are possible: It is usually not enough to look at the P/E ratio of one company and determine its status. Usually, an analyst will look at a company's P/E ratio compared to the industry the company is in, the sector the company is in, as well as the overall market (usually the S&P 500). Sites such as Reuters offer these comparisons in one table. Example of RHAT Oftentimes, comparisons will also be made between quarterly and annual data. Only after a comparison with the industry, sector, and market can an analyst determine whether a P/E ratio is high or low with the above mentioned distinctions (i.e., undervaluation, over valuation, fair valuation, etc). The Market P/E To calculate the P/E ratio of a market index such as the S&P500, it is not accurate to take the "simple average" of the P/Es of all stock constituents. The preferred and accurate method is to calculate the weighted average. In this case, each stock's underlying market cap (price multiplied by number of shares in issue) is summed to give the total value in terms of market capitalization for the whole market index. The same method is computed for each stock's underlying net earnings (earnings per share multiplied by number of shares in issue). In this case the total of all net earnings is computed and this gives the total earnings for the whole market index. The final stage is to divide the total market capitalization by the total earnings to give the market P/E ratio. The reason for using the weighted average method rather than 'simple' average can best be described by considering a recessionary period of the economic cycle, where a number of stocks would be reporting a loss. For example, a company with a share price of $100, may have made a slight loss of say 10 cents giving a P/E ratio of -1000 (100/0.1). In another case, a company with a share price of $1 may have made a serious loss of 50 cents giving a P/E ratio of - 2 (1/0.5). This mathematical anomaly would create a misrepresentation of the underlying company losses on the overall market index. The P/E & Inflation There is evidence that the P/E of the market has more to do with changes in consumer prices than any other factor. From 1900 to 2005, the highest average P/E occurred when the average change in consumer prices was 2.6%. In general, the P/E ratio is inversely proportional to the absolute value of the change in prices, in other words, the higher the price change, the lower the P/E. Some claim that the P/E ratio is mostly dictated by interest rates, but the level of correlation of P/E ratios to interest rates is much lower versus that to the magnitude of price change. An example An easy and perhaps intuitive way to understand the concept is with an analogy: Let's say, I offer you a privilege to collect a dollar every year from me forever. How much are you willing to pay for that privilege now? Let's say, you are only willing to pay me 50 cents, because you may think that paying for that privilege coming from me could be risky. On the other hand, suppose that the offer came from Bill Gates, how much would you be willing to pay him? Perhaps, your answer would be at least more than 50 cents, let's say, $20. Well, the price earnings ratio or sometimes known as earnings multiple is nothing more than the number of dollars the market is willing to pay for a privilege to be able to earn a dollar forever in perpetuity. Bill Gates's P/E ratio is 20 and my P/E ratio is 0.5. Now view it this way: The P/E ratio also tells you how long it will take before you can recover your investment (ignoring of course the time value of money). Had you invested in Bill Gates, it would have taken you at least 20 years, while investing in me could have taken you less than a year, i.e. only 6 months. If a stock has a relatively high P/E ratio, let's say, 100 (which Google exceeded during the summer of 2005), what does this tell you? The answer is that it depends. A few reasons a stock might have a high P/E ratio are: Accuracy and context In practice, decisions must be made as to exactly how to specify the inputs used in the calculations. Historical vs projected earnings A distinction has to be made between the fundamental (or intrinsic) P/E and the way we actually compute P/Es. The fundamental or intrinsic P/E examines earnings forecasts. That is what was done in the analogy above. In reality, we actually compute P/Es using the latest 12 month corporate earnings. Using past earnings introduces a temporal mismatch, but it is felt that having this mismatch is better than using future earnings, since future earnings estimates are notoriously inaccurate and susceptible to deliberate manipulation. On the other hand, merely because a stock is trading at a low fundamental P/E is not an indicator that the stock is undervalued. A stock may be trading at a low P/E because the investors are less optimistic about the future earnings from the stock. Thus, one way to get a fair comparison between stocks is to use their primary P/E. This primary P/E is based on the earnings projections made for the next years to which a discount calculation is applied. The P/E concept in business culture The P/E ratio of a company is a significant focus for management in many companies and industries. This is because management is primarily paid with their company's stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders), in order to increase the stock price. The stock price can increase in one of two ways: either through improved earnings or through an improved multiple that the market assigns to those earnings. As mentioned earlier, a higher P/E ratio is the result of a sustainable advantage that allows a company to grow earnings over time (ie, investors are paying for their peace of mind). Efforts by management to convince investors that their companies do have a sustainable advantage have had profound effects on business: These and many other actions used by companies to structure themselves to be perceived as commanding a higher P/E ratio can seem counterintuitive to some, because while they may decrease the absolute level of profits they are designed to increase the stock price. Thus in this situation maximizing the stock price acts as a perverse incentive. Dividend Yield Publicly traded companies often make periodic quarterly or yearly cash payments to their owners, the shareholders, in direct proportion to the number of shares held. By law such payments can only be made out of current earnings or out of reserves (earnings retained from previous years). The company decides on the total payment and this is divided by the number of shares. The resulting dividend is an amount of cash per share. The dividend yield is the dividend paid in the last accounting year divided by the current share price. If a stock paid out $5 per share in cash dividends to its shareholders last year and its price is currently $50, then it has a dividend yield of 10%. Historically, at severely high P/E ratios (such as over 100x), a stock has NO (0.0%) or negligible dividend yield. With a P/E ratio over 100x, and supposing a portion of earnings is paid as dividend, it would take over a century to earn back the purchase price. Such stocks are extremely overvalued, unless a huge growth of earnings in the next years is expected. Related concepts The P/E is calculated primarily for common shares, not for preferred shares. The appropriate calculation for preferreds is the preferred dividend coverage ratio. A related concept is the "PEG ratio". This is the P/E ratio adjusted by a growth coefficient. It is sometimes used in high growth industries and new ventures. Its use is controversial. Another practice, which is not mainstream, based on behavioral finance, is to take market behavior parameters, among which the stock image, as factors playing a part in the level and evolution of the P/E. The P/E can be applied not only to shares, but to other assets also. Thus the P/E, comparing Price to Rental Incoming for housing, is an important measure in determining the existence or absence of Property bubbles. See also Data | |||||||
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