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.
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