Price to Earnings Ratio – Introduction and Interpretation

Price to Earnings Ratio (P/E) is an analysis tool used to evaluate publicly traded stockIt is a simple mathematical formula relating the stock price in the market against the prior 12 months of earnings.  The following is the formula: 

Price to Earnings Ratio = Current Stock Price in the Market/Prior 12 Months of Earnings per Share 

It is most commonly used by investors (buyers of stock) to determine the likelihood that the current trading price of the stock is beneficial or detrimental to the buyer.  Historical trigger points to investing in the stock have been ratios of 19 or less.  As an example, if the current price of the stock is $81 then to have a ratio of 19 or less, the earnings would have to have been $4.26 or more during the previous 12 months. 

P/E ratio of 19 = $81 Current Stock Price/Unknown
Solve for the unknown:  19 = 81/X
Therefore:                       19/81 = 4.26 

As a buyer, the lower the P/E the more beneficial the opportunity to purchase the stock.   If you are selling stock, the higher the P/E the greater the opportunity to make money.  How so? 

Purchasing Stock in the Market

As a company earns money it has to utilize those earnings in some fashion.  It may distribute the earnings to the shareholders via dividends or retain the money to continue expansion of operations or reduce debtMost commonly, both are exercised with earnings.  Most companies will pay some of the earnings out as dividends and retain the balance to benefit the corporate financial situation.  As a buyer of stock, you are interested in your investment having the maximum earnings per share of stock.  So evaluate the most recent history of this criterion, the price to earnings ratio is your best tool.  As the P/E decreases, it means that the price on the market per share is more valuable because there are greater earnings per share in comparison to the market price.  The following chart illustrates this relationship:

Per ShareEarnings   Stock Price   P/E Ratio
       $2.71                       $62.33          23
         2.71                         53.85          19.87
         2.71                         46.50          17.16
         2.71                         38.00           14.02 

The chart illustrates that as the earnings remain the same, as the share price decreases, the P/E ratio also decreases.  Therefore when evaluating stock, the lower the P/E, the stock becomes increasingly more valuable as a buy. 

Selling Stock in the Market

Naturally as an investor in stock, you desire to buy low and sell high.  The higher the price to earnings the less likely other investors will desire to purchase the stock.  However, it doesn’t mean that someone isn’t going to buy the stock; it just means there are fewer buyers in the market.  Therefore, as the P/E begins to increase the stronger the impetus to sell the stock. 

As a student of investing, this tool is merely a relationship formula.  It doesn’t mean that you base your buying and selling on just this analysis.  The following explains this concept in more detail. 

In the traditional stock purchase and sell relationship, the buyer buys low and sells high.  If you transfer this relationship and based it solely on the price to earnings ratio, you may not make a return on your investment.  Suppose you purchase a share of Company ‘A’ for a P/E ratio of 16 for a price of $38.  This means that Company ‘A’ earned $2.38 per share during the prior 12 months.  In keeping with your only criterion of the P/E as the determining factor in buying and selling, let’s say the new P/E is 19.  So you want to sell at 19 after buying at 16.  

There may be a problem.  If the earnings have dropped to half of the earnings when you purchased the stock, this means that based on the P/E you are selling the stock for $22.61.  The following chart illustrates the relationship: 

                     Per Share
Earnings        Stock Price      P/E Ratio
  $2.38               $38.00                16
    1.19                 22.61                19 

Notice your sole criterion of only trading based on the Price to Earnings Ratio.  You buy low and sell high.  In this case you would lose $15.39 per share.  The key to this ratio is that it only reflects the most recent 12 month period of activity and therefore it should not be your only tool in determining the buy and sell points. 

What is really interesting about the price to earnings ratio is that it has more negative attributes than positive attributes.  How can this be?  After all, every market guru uses the term frequently and actually they throw it out there like it’s the only form of evaluating stock.  Well let me explain.  

Historical Evaluation Tool

The primary purpose of the tool is to evaluate the price of the stock to the most recent four quarters of earnings.  This is the most positive attribute of the P/E ratio.  In more advanced terminology this is referred to as the trailing price to earnings ratio.  However, some market analysts will use the term ‘leading price to earnings ratio’.  This means that they are changing the earnings amount to the expected amount over the next four quarters.  Ooh…, notice now that the value is becoming riskier in nature because the formula is using expected earnings.  Often, market analysts overestimate the potential earnings; therefore the leading P/E is overstated.  This is a negative attribute related to using this formula in evaluating your purchase or sale of the stock. 

Industry Comparison

Many so called gurus or analysts use this tool to compare companies between different industries.  This is an improper use of the relationship.  Remember, the P/E is based on the price per share against the earnings per share.  In many industries, the stability is greater and therefore earnings are more predictable.  With stability comes security via reduced risk exposure with the stock purchase.  Over time, the P/E’s for these industries decrease because there is limited upside potential.  Whereas those industries with high growth and higher expectations of increased value there tends to be higher P/E ratios.  So if the only criterion used to compare one company to another is the P/E; be careful to limit this comparison to industry related investments.  The following is an example using three different businesses as of January 9, 2015: 

   Name of Company         Industry      Earnings      Price      P/E
   Walmart                           Retail            $5.04            $89        17.70
   Union Pacific                   Railroad        4.63            115        24.86
   Kansas City Southern    Railroad        3.95            114        28.92 

Walmart is the number one company worldwide right now.  The upside potential is limited due to the natural dampening effect of expansion when you are already the number one player in this industry.  

Now look at the two railroad companies.  Notice how both have really high P/E’s?  This is because there is a lot of expectation of greater earnings in the upcoming year for these two companies.  But notice the differential between the two industries.  You don’t want to compare the P/E of the railroad industry against retail even though the earnings are relatively close.  

Company Growth Rates

This concept of using the P/E as a comparison tool is also applicable right down to the company level.  Each company has different growth rates.  Younger companies have a tendency to grow at faster rates than mature larger companies.  Therefore the P/E’s often reflect this potential.  This is where more mature investors use caution and experience to properly evaluate the stock. 

Negative Earnings

The price to earnings ratio has zero value when the earnings go to zero or below.  Think about this for a moment, how do you evaluate a negative earnings company using the earnings in the formula?  It can’t be done.  More advanced investors acknowledge this shortcoming and review the financial statements in depth to look at one time charges against earnings or to evaluate the source of the earnings deficiency.  Often earning deficits relate to economic issues that are temporary and this provides opportunities for investors to pick up stock at good prices. 

Publicly Traded Stocks Only

In small business, I often hear the owners of companies talk about applying the P/E ratio to their own stock.  DON’T USE THE P/E RATIO IN SMALL BUSINESS.  The ratio is for large markets with many savvy investors and knowledgeable analysts.  Its application in a limited market provides no distinct advantage.  It is even difficult to use this in any form in the over the counter market (OTC).  So please, do not use it in small business and if you hear your colleagues exercising the term for their business, realize that they may not be a true sophisticated businessman and stay silent. 

Overall, the price to earnings ratio is just one tool in the arsenal of different ratios, financial statements, notes and industry standards used by investors in determining the value of a particular stock.  For you, you need to understand what the term means and of course the various limitations for its use.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on My Services in the footer of this article.

 

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About David J Hoare 427 Articles
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns