Price/Earnings Ratio (P/E Ratio)

Common stock ratios (aka market ratios) are based on financial data from income statements, balance sheets, or the cash flow statements of financial reports of the company, and divides it by the number of outstanding common shares so that the financial data can be presented on a per-share basis, which makes it easier to compare it to other stocks.

The price/earnings ratio (aka P/E ratio) is the most widely published ratio on stocks, equal to the company’s stock price divided by its earnings per share.

Price/Earnings (P/E) Formula
Price/Earnings Ratio =Stock Price
EPS

Earnings per share (EPS) is equal to the company’s net income minus the dividends paid to preferred stockholders and divided by the number of common shares outstanding.

Earnings Per Share (EPS) Formula
Earnings Per Share (EPS) =Net Income - Preferred Dividends
Number of Common Shares Outstanding

A trailing P/E ratio is based on the earnings per share from the company’s last fiscal year’s earnings, or the last 4 quarters; a forward P/E ratio is based on earnings for the current or the next year as projected by a consensus of analysts. Many financial websites list both the trailing and the forward P/E ratios of companies.

Common stock is stock that is held by investors; it does not include treasury stock which is stock bought back by the company.

The P/E ratio is only useful in comparing companies that have net income; a company without net income has no earnings and therefore no P/E ratio. Such companies can be compared by using other formulas, such as price per sales or enterprise value, because these formulas have a value regardless of the financial condition of the company.

The P/E ratio varies considerably among different companies, even if they have the same net income. A higher P/E ratio usually reflects a higher expectation of future company growth. Therefore, almost all large, mature, stable companies will have relatively low P/E ratios, because there is little possibility for rapid growth, since diseconomies of scale grow with size, which hinders growth—the bigger a company already is, the harder it is for it to grow even more. Hence, only relatively small companies have a high potential for growth, and it is these companies that are more likely to have high P/E’s, at least for those which investors expect to grow rapidly in the near future. Some companies have such high P/E’s that their market value can be greater than companies that are actually much larger. In 2007, for instance, Google (GOOG) had a larger market value than Wal-Mart (WMT), which is one of the largest companies in the world.

Another reason why the P/E ratio may be high is because earnings have dipped from recent times, and the stock price doesn’t yet reflect the lower earnings, or because investors believe the earnings dip is temporary and that the company still has a large potential for growth.

Investing in a company with a high price/earnings ratio is risky, because it will fall faster and further in an economic downturn than one with a low P/E. Google, for instance, lost more than half of its value during the market downturn in late 2008, while Wal-Mart actually increased slightly. Even without an economic downturn, however, a high P/E will trend downward as the company's potential for further growth declines as its size increases.

Generally, the P/E ratio is increased by:

  1. higher earnings growth rate
  2. higher dividend amount
  3. larger investments in the stock market

and decreased by:

  1. a greater proportion of debt in a firm's capital structure
  2. higher current and expected rates of inflation

A higher amount of debt incurs greater risk, and therefore, requires a higher rate of return to compensate the investors for the risk, which lowers the P/E ratio compared to a similar firm with the same earnings, but no debt.

The relationship of P/E with inflation is more complex, but, generally, companies' earnings are higher because of the higher inflation, which increases the denominator of the P/E ratio, hence, lowering it. Furthermore, higher inflation increases the required rate of return to keep the real rate of return commensurate with the stock's real risk, which lowers the market price of the stock, which lowers the P/E ratio.

Relative P/E Multiple

Whether a P/E ratio is too high or too low is often gauged by comparing it to the market P/E multiple, which is the average P/E ratio for a major group of stocks, such as the S&P 500 or the NASDAQ stock market. A relative P/E multiple for a stock can be calculated by dividing the stock's P/E ratio by the market multiple.

Relative P/E Multiple Formula
Relative P/E Multiple =Stock P/E
Market P/E

A higher relative P/E multiple is a greater indication of increased risk than the P/E itself, since P/E ratios have varied widely over the years, depending on the amount of money invested in the stock markets. A stock with a high relative P/E multiple must outperform the market to maintain its multiple.

Example—Calculating the Relative P/E Multiple of a Stock

If a stock has a P/E ratio of 30 and the general market multiple is 20, then:

Stock's Relative P/E Multiple = 30/20 = 1.5

PEG Ratio

Price/earnings ratios are not too meaningful in themselves—a high P/E could indicate that the company is growing rapidly and is expected to continue doing so, or it may indicate that it is overpriced, and bound to fall. Likewise, a low P/E may indicate that the company is not growing and is unlikely to grow much in the future, or it may indicate that the stock is underpriced. Thus, it would behoove the investor to ascertain the likely reason for a company’s P/E ratio.

The PEG ratio (Price/Earnings divided by Earnings Growth Rate) is another common stock ratio that gives more information about the company, and what its P/E ratio really means, and is equal to the stock’s P/E ratio divided by a 3- to 5-year growth rate in earnings.

PEG Formula
PEG Ratio =P/E Ratio
Earnings Growth Rate

Example—Calculating Google’s PEG Ratio

On December 7, 2008, Google had a trailing P/E ratio of 17.15 and its quarterly earnings growth was 20.6%. What is its PEG ratio based on this information?

PEG Ratio = 17.15 / 20.6 = 0.8325

Note that the growth rate is not treated as a percentage in the denominator, but as general number. Because Google's PEG ratio is less than 1, many investors would consider it a good buy.

Many investors believe that a company's earnings growth rate should approximate its P/E ratio. If the PEG ratio is significantly less than 1, then the stock is undervalued, and therefore a good buy; if it is significantly greater than 1, then it is probably overpriced, and should be sold or avoided.