Price/Earnings (P/E) Ratio
Price/Earnings or P/E ratio is the ratio of a company's share price to its earnings per share. It tells whether the share price of a company is fairly valued, undervalued or overvalued.
|P/E Ratio =||Current Share Price|
|Earnings per Share|
Current share price is obtained from secondary markets like NYSE, NASDAQ, etc. while EPS is calculated as (net income minus preferred dividends)/weighted average number of shares outstanding.
Leading and Trailing P/E Ratio
If the EPS is the figure for the current period the P/E ratio is called trailing P/E ratio. For better analysis the EPS should be the one expected to prevail in the next reporting period, say next year. P/E ratio calculated based on expected P/E ratio is called leading P/E and is a more meaningful estimate of the company's justified P/E ratio.
For financial analysis justified P/E ratio is calculated using dividend discount method.
|P/E Ratio =||Expected Payout Ratio|
|Required Rate of Return − Dividend Growth Rate|
If the justified P/E calculated using dividend discount analysis is higher than the current P/E ratio the share is undervalued and should be purchased. If the justified P/E is lower than P/E ratio the share is overvalued and should be sold.
A share of T Ltd. has current market price of $20 and it's EPS for current period is reported as $2. It's EPS for next period is expected as $2.5, expected payout ratio is 40%, required rate of return is 12% and growth rate is 6%. Find the trailing P/E, leading P/E and justified P/E.
Trailing P/E = current share price/current year EPS = $20/$2 = 10
Leading P/E = current share price/next year EPS = $20/$2.5 = 8
Justified P/E = payout ratio/(required rate of return − growth rate) = 40%/(12% − 6%) = 40%/6% = 6.67
Reciprocal of P/E ratio is called earnings yield (which is EPS/price).