One of the most commonly used tools in corporate valuation is ratio analysis. Ratio analysis is a method of financial statement scrutiny where company-specific financial data is examined to identify the current health of a company. Ratios fall into several different categories: debt management, liquidity and solvency, profitability and market value.
P/E Ratio: Calculation
The price to earnings ratio (P/E) provides an illustration of the relationship between a company's stock price and its earnings. Characterised as a "market value" ratio, P/E directly includes current stock price in its derivation.
In order to calculate a P/E ratio, earnings per share (EPS) must be quantified. EPS serves as the denominator for the ratio and is calculated as follows:
- Earnings per share= (Net Income) / (Number of Shares Outstanding)
After the calculation of earnings per share, the formula for the P/E ratio may be used:
- P/E = (Current Stock Price) / (Earnings Per Share)
For example, assume company X is currently trading at US$100 per share, with a net income of US$50 million and 5 million shares outstanding. The P/E ratio is calculated in the following fashion:
- Earnings per share: (US$50 million) / (5 million shares outstanding) = US$10
- P/E: (US$100) / (US$10) = 10
- Company X's P/E is 10
In isolation, the P/E number of 10 looks a bit abstract and its usefulness in terms of establishing a value for X is limited. However, when viewed in comparison to similar companies, the P/E ratio is placed in context and X's performance is measured relative to its peers.
P/E Ratio: Application And Interpretation
The P/E ratio is a tool that evaluates corporate worth according to its most important attributes: current stock price and net income. For instance, assume that company A is a rival corporation within X's sector and has a P/E ratio of 50. In comparison, X has a P/E of 10. Company X has a lower P/E than company A, and the interpretation of the statistical comparison is two-fold:
- X has a lower P/E, thus is considered by the market to be more of a bargain than A. The reason for this is that X's current market price is not reflecting earnings.
- Company A has a higher P/E, and thus is seen by the market to have greater growth potential in regards to future earnings.
P/E ratios are useful in that they can help investors identify companies with growth potential as well as companies that are in danger of a dramatic price correction. As a rule of thumb, companies with low industry-specific P/Es are poised for sustained growth, while companies that trade with high P/Es are over-priced and could be headed for a selloff.
P/E Ratio: Limitations
It is important to keep in mind that the P/E ratio is used to compare companies to one another, and it's not necessarily independently significant. Given the proper circumstances, the P/E ratio provides context for a company within its sector and is a useful analytical tool for investors.
However, it is possible for a P/E ratio to be a misleading indicator of company performance. Listed below are a few situations that undermine the relevance of a P/E ratio:
- Overvalued industrial sector: A company's entire sector has inflated stock prices because of investor optimism. Often, this situation is referred to as a "bubble."
- Periodic inflated earnings: The sale of corporate assets can provide an abnormal increase in earnings. This spike in earnings can skew the P/E ratio in an unrealistic fashion.
- Cyclical nature of business: Many businesses exist in cyclical industries. Automobile manufacturers, real estate developers and energy production companies are a few examples of firms that exhibit earnings on a rotating basis.
Any of the above listed situations can greatly diminish the value of a P/E ratio. It is imperative that a trader or investor is abreast of the many economic factors surrounding a firm and not just accept the P/E ratio as the ultimate measure of corporate value.
Although the P/E ratio provides a method of valuing and comparing a stock, it is not a golden ticket to financial windfall. As in all other aspects of trading, buyer beware. Performance of due diligence, such as market and corporate research, is required to gain a complete understanding of a stock's valuation and potential.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. Friedberg Direct will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.