Price/Earnings Ratio

There is no doubt that the most popular ratio is P/E, or the share price divided by the earnings per share. In simple terms, it can be taken to indicate the amount of time over which a company should sustain its current earnings so that it generates enough money to pay back the current share price.

When calculating this multiple, the market price is obvious, so the problem becomes the earnings per share, which can differ significantly across sources. In one place, you may find the raw earnings per share from the income statement, while another may provide you with a figure recalculated in a way that the source or analyst considers more representative of the earnings for valuation purposes. Besides through various recalculations, the multiple may end up inconsistently computed because of the period associated with these earnings. It is possible to take into account those generated in the past fiscal year or to use trailing P/E, which are earnings over the last four quarters. Quite often, valuations reflect forward P/E, which incorporates the profit expected in the new year. Forward P/E is often considered the most appropriate multiple to use for valuations since it also includes expectations for the company’s progress instead of just historical data.

The use of the ratio requires employing the same method of determining P/E. Access to this metric is extremely easy as it can be found on virtually all financial websites providing stock market data. If we use a single source of information, we rely on it having consistent calculations although this is seldom mentioned explicitly in free databases.

In principle, P/E is used for companies which are not threatened by problems resulting from heavy debt. They have their typical rate of return, and their revenue growth is in single rather than double digits. If we make an analogy with the methods based on net present value, the most appropriate match would be stable growth company valuation .

P/E may not be the right choice for companies whose debt levels are so high as to trouble the market, which often zeroes in on a single issue. If a company’s liabilities concern it, more appropriate would be multiples which take debt into account, EV/EBITDA being an example.

With a very fast-growing company, P/E may shoot up to 50, 100, or even higher. On the other hand, if its peers are growing at similar rates, we could still decide in favor of using this multiple, but that is hardly a good idea. The potential error could be quite serious when dealing with extremely high P/E. It is more appropriate to use P/S, replacing earnings per share (EPS) with sales per share and the PE of peers with their P/S in the calculator for average P/E.

In the case of cyclical businesses, P/E may also fail to reflect properly the relative value of a company. Its profits will be high at the top of the cycle, but its P/E is very likely to be low since the market will have priced in expectations for an earnings decline. If the business is in a cyclical downturn, the reverse will happen – the P/E will be extremely high due to expectations for improvement while the profit will be low. Whenever we use P/E for a cyclical business (car manufacturing, natural resources extraction, machinery production, construction, etc.), it is a good idea to draw our conclusions about the company with consideration for the stage of the cycle it is in. Otherwise, the conclusions reached through the use of the ratio may be horribly wrong.

Once we have determined that P/E is appropriate to use, we can proceed in one of several ways.

• We can compare the multiple with that of similar companies.
• We can use it to include new information about the company in its price.
• We can calculate a theoretical P/E and compare it to the market multiple.

Calculating a theoretical P/E multiple for a growing company poses a serious challenge. In this case, we need to find the net present value of the company by using the calculator for a growing business and proceed from there to determine P/E. The theoretical P/E model on this page uses the valuation model for a stable company. However, if we want a more accurate assessment of the PE suitable for a given company, it is still advisable to use a concrete calculation of company value through net present value and then derive an appropriate ratio.

P/E provides only a comparative assessment of a company’s value, but since its numerator contains the market value, the fundamental valuation models can express the factors which influence its parameters.

All other things being equal, the factors are:

• Revenue growth – the higher the growth rate, the higher the P/E;
• Company risk – the lower the risk, the higher the P/E. In other words, if we have a company with a beta of 1.5 and another with 1, we can expect the former to have a lower P/E multiple;
• The share of net profit in EBIT – the higher the share, the lower the P/E.

The final point requires a more detailed explanation. Since free cash flows, not profits, are used to value a company through the discounted cash flow model, and we use EBIT to calculate net cash flows, the fundamentally as opposed to relatively determined value of the company will not depend on net profit (which is a factor in P/E) but on EBIT. Some companies may have low net profits as a percentage of revenues but significantly higher free cash flows. Such companies will most likely trade at a higher P/E. Net profit margin and operating profit margin are input as variables in the calculator for theoretical computation of an appropriate P/E, serving as proxy parameters for calculating theoretical P/E.

The main problems associated with using P/E stem from the specifics of profit. A company may be operating at a loss or have very low profits, which implies negative or extremely high P/E. In such case, we cannot use this multiple.

Even if the company’s profitability is normal in the period for which P/E is being calculated, its earnings may not be attributable to a regular business we can expect to continue in the future but to extraordinary revenues or expenses that will not be repeated. If so, we need to adjust the earnings to reflect the extraordinary components affecting the result or go with another method of valuation.

Earnings are far more dependent on the accounting presentation of a company’s results, which also makes them an indicator easier to manipulate.