Price to Earnings Ratio

P/E ratio (i.e. price to earnings ratio) is the ratio of a company’s current stock price to its earnings per share. By comparing P/E ratios, we can identify undervalued and overvalued stocks.

There are two variants of P/E ratio: (a) trailing P/E ratio, which is calculated by dividing current stock price by last year EPS and (a) forward P/E ratio, which is calculated by dividing the current stock price with expected next year EPS.

Price to earnings ratio tells us the dollars that must be invested in a company to earn one dollar each year. It measures how costly a stock is with reference to its ability to earn income. P/E ratio is compared across time and cross sectionally i.e. between different companies. When the P/E ratio of a company is higher than its competitors, there is a possibility that the stock might be overvalued and vice versa.

Trailing P/E ratio

Trailing P/E ratio is calculated by dividing the current stock price of a company by the last year earnings per share (EPS). It is the most common definition of price-to-earnings ratio. When we say just the P/E ratio, we mean the trailing P/E ratio.

Trailing P/E Ratio =P0
EPS0

Where P0 is the current stock price and EPS0 is the last year annual earnings per share.

Forward P/E ratio

Forward P/E ratio is the price-to-earnings ratio variant which is calculated by dividing the current stock price by the earnings per share expected in the next 12 months.

Many investors and analysts prefer the forward P/E ratio because they believe that historical performance is not a particularly good indicator of future performance and that undervaluation or over-valuation of a stock should be determined by comparing its current price with earnings expected in future.

Forward P/E Ratio =P0
EPS1

Where EPS1 is the earning per share expected in the next 12 months.

Justified P/E ratio

A justified P/E ratio is the price to earnings ratio which is justified by the company’s underlying fundamentals, i.e. growth rate and cost of equity, etc.

Justified P/E ratio can be determined by linking the P/E ratio with the Gordon growth model. Gordon growth model (GGM) is a single stage dividend discount model which determines a stock’s current stock as equal to the present value of a perpetuity comprising of the stock’s dividends. GGM equation is as follows:

P0 =D1
ke − g

Where P0 is the current stock price, D1 is the dividend per share next year, ke is the cost of equity and g is the growth rate.

Dividing both sides by E1, the earning per share expected next year, the left hand of the above equation equals the forward P/E ratio and the numerator of the right-hand side equals the dividend payout ratio (DPR):

P0= D1/EPS1= DPR
EPS1ke − gke − g

The above equation can be used to find out the P/E ratio indirectly based on the company’s dividend payout ratio, cost of equity and dividend growth rate. This P/E ratio is called the fundamental P/E ratio or justified P/E ratio.

Example

Let us calculate the trailing P/E ratio and forward P/E ratio for Intel Corporation and compare it with its justified P/E ratio to see if the stock is overvalued or undervalued:

  • Current stock price is $54.51
  • Trailing twelve-month (TTM) earnings per share (EPS) is $1.99
  • EPS expected in next 12 months is $2.15
  • Dividend payout ratio is 48%, cost of equity is 9.5%% and growth rate is 7.6%

The trailing P/E ratio equals current stock price of $54.51 divided by last year EPS of $1.99. It works out to 27.31 (=$54.51/$1.99).

The forward P/E ratio (also called leading P/E ratio) equals P0 of $54.51 divided by next-year EPS (EPS1) of $2.15; it works out to 25.35 (=$54.51/$2.15)

The justified P/E ratio can be calculated as follows:

P0= DPR= 48%= 25
EPS1ke − g9.5% − 7.6%

Since the justified P/E ratio is close to the current forward P/E ratio, the stock seems to be fairly priced.

by Obaidullah Jan, ACA, CFA and last modified on

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