Importance of Price to Earnings Ratio (P/E Ratio)

Price to Earnings Ratio

The most popular ratio used to assess the value of the equity is the company’s price equity ratio abbreviated as P/E ratio. It is calculated as the ratio of the firm’s current stock price divided by the earnings per share (EPS). The inverse of the P/E ratio is referred to as the earnings yield. Clearly the price earning and the earnings yield are required to measure the same thing. In practice earnings yield less commonly stated and used than P/E ratios.

P/E Ratio = Market Value per Share/ Earnings per Share (EPS)

Since most companies report earnings each quarter annual earnings per share can be calculated as the most recently quarterly earnings per share times four or as the sum of the last four quarterly earnings per share figures. Most analysts prefer the first method of multiplying the latest quarterly earnings per share value time four. However the difference is usually small, but it can sometimes be source of confusion.

Analysts often refer to high P/E stocks as growth stocks. To see why notice that a P/E ratio is measured as a current stock price over current earnings per share. Now consider two companies with the same current earnings per share, where one company is a high growth company and the other is a low growth company. Which company should have a higher stock price, the high growth company or the low growth company? The question is a no brainer. These entire equal, we would be surprised if the high growth company did not have a higher stock price and therefore a higher P/E ratio. In general companies with higher expected earnings will have higher P/E ratio, which is why P/E stocks are referred to as the growth stocks.

The reason why they are referred to high growth stock is simple. The reason is that low P/E value stocks are often viewed as cheap relative to current earnings. This suggests that these stocks may represent good investment values, and hence the term values stocks. However it should be rated that the term growth stock and value stock are most justly commonly used labels. Of course only time will tell whether a low P/E stock is of good value.

Factors that Influence a Company’s P/E Ratio

The P/E ratio used in the business valuation is influenced by the following factors:

  1. P/E ratios for a group of companies tend to change little from one period to the next. Therefore an investor cannot expect a dramatic change in the future P/E ratios. The future level of the P/E ratio can be viewed as the function of the current P/E ratios or the average P/E ratio over the same period of time.
  2. The P/E ratio is a function of future expected earnings the higher the growth rate of earnings the higher will be the P/E ratio. An investor will be willing to pay a higher price forth-current earnings if the earnings are expected to grow at a much higher rate.
  3. A normal P/E ratio for the market is difficult to determine. A normal P/E ratio is established for each company but it can be compared to the market P/E to give some idea of risk. The higher the P/E ratio the higher is the risk. This is true inspite of the fact that the investors are ready to pay more.
  4. Inflationary conditions tend to reduce the P/E ratios.
  5. Higher interest rates tend to reduce the P/E ratios.
  6. The level of P/E ratio is not an absolute one but a relative one.
  7. Speculative companies and cyclical companies tend to have a lower P/E
  8. Growth companies tend to have a higher P/E
  9. Companies with larger portion of debt tend to have a lower P/E
  10. A company that tends to pay a higher dividend tend to have a higher P/E
  11. P/E ratios can change radically and suddenly because of change in the expected growth rate of earnings. Therefore the greater the expected stability of the growth rates the higher the P/E ratio.
  12. An investor should examine the trend of the P/E ratio over time for each company.
  13. P/E ratios vary by the industry.

P/E Ratio in Investment Decisions

How can the P/E ratio be used as guide in making an investment decision? For this an investment analyst need to apply various rules of thumb on company’s earnings selecting an appropriate P/E ratio to determine the value of its shares. The resulting price is to be compared with current market price to assess the relative magnitude of the ratio. Taken from the historical record of the equity in question the determination of the current equity must be followed by a standard of comparison. For this the analyst must ascertain the median or the mean P/E for the equity as well as its range over the time. More weight can be given to the recent past. This provides boundaries within which the P/E must fall and indicates whether the equity is tending to sell at the upper limits of expectation or the lower limits. Industry P/E provide the guidelines, however the different companies in the same industry frequently carry different P/E ratios.

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