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|
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|
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:
|ke − g|
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):
|EPS1||ke − g||ke − 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.
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:
|EPS1||ke − g||9.5% − 7.6%|
Since the justified P/E ratio is close to the current forward P/E ratio, the stock seems to be fairly priced.