Price-Earnings (P/E) Ratio

Price-earnings ratio or P/E ratio is the ratio of a company's share price to its earnings per share. It is an indicator of whether a company’s stock is fairly valued, undervalued or overvalued as compared to its peers.

A high price-earnings ratio means that each dollar of earnings that the company generates is costly as compared to those of a company whose price-earnings ratio is low.

Price-earnings ratio can be calculated only for a company whose stock is traded on a public exchange.

Formula

The price-earnings (P/E) ratio can be calculated using the following formula:

P/E Ratio = Current Share Price
Earnings per Share

Current share price is obtained from secondary markets like NYSE, NASDAQ. Earnings per share (EPS) can also be calculated by dividing net income attributable to common shareholders by the weighted average number of common shares outstanding. However, most often it is disclosed by companies in their income statement.

Trailing P/E ratio vs leading/forward P/E ratio

While price-earnings ratio is most often calculated using the formula discussed above, there are different variants of the ratio and the calculation may differ depending on the point of reference.

The trailing P/E ratio is calculated by dividing current stock price current period earnings per share. However, most often analysts want to value a company based on its expected earnings per share. Hence, they are interested in the leading P/E ratio, which is calculated by dividing current stock price by expected future earnings. Leading P/E is also called forward P/E ratio and justified P/E ratio.

Analysis

For financial analysis, justified P/E ratio is calculated using the dividend discount model.

P/E Ratio = Expected Payout Ratio
Required Rate of Return − Dividend Growth Rate

If the justified P/E ratio is higher than the current P/E ratio, the share is undervalued and may be a good investment, but if the justified P/E ratio is lower than the current P/E ratio, the share is overvalued and should not be considered for investment.

Example

The current price of a share of T Ltd. is $20 and its current period EPS is $2. If the next-year EPS is expected to be $2.5, the expected payout ratio is 40%, the required rate of return is 12% and the growth rate is 6%, find the trailing P/E ratio, leading P/E ratio and justified P/E ratio.

Solution

Trailing P/E Ratio = $20 = 10
$2
Leading P/E Ratio = $20 = 8
$2.5
Justified P/E Ratio = $40% = 6.67
12% - 6%

Reciprocal of the P/E ratio is called earnings yield (which equals EPS/price).

by Obaidullah Jan, ACA, CFA and last modified on

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