How to Calculate Price Earnings Ratio (with Example)

The Price Earnings Ratio (P/E) is one of the most widely used and recognized financial metrics in the world of investing and stock market analysis. As a valuation tool, it compares the current market price of a company’s share to its earnings per share (EPS), providing investors with a simplified means of assessing a company’s valuation relative to its earnings. The P/E ratio plays a crucial role in the investment decision-making process, as it offers valuable insights into how much investors are willing to pay for each dollar of earnings a company generates. However, like any financial metric, the P/E ratio comes with its own set of advantages and limitations that investors must be aware of when making investment decisions.

Understanding the Price Earnings (P/E) Ratio

The P/E ratio is calculated by dividing the market price of a company’s stock by its earnings per share (EPS).

Formula:

Price Earnings Ratio = Market price per share / Earnings per share

Where:

Price per Share refers to the current market price of a single share of the company. Earnings per Share (EPS) represents the company’s net income divided by the number of outstanding shares. The P/E ratio provides a numerical value that reflects how much investors are willing to pay for a company’s earnings. For example, if a company’s stock is trading at $100 per share and its earnings per share (EPS) is $5, the P/E ratio would be 20 ($100 ÷ $5). This means that investors are willing to pay 20 times the company’s earnings for each share.

The P/E ratio is often categorized into two main types:

Trailing P/E Ratio: This is based on the company’s historical earnings, typically from the last 12 months. The trailing P/E is the most common version of the ratio used by analysts and investors. It reflects the company’s past performance and gives investors a sense of how the market has valued the company relative to its actual earnings.

Forward P/E Ratio: This version of the P/E ratio uses projected earnings for the next 12 months. It provides insight into how the market values a company’s future earnings potential. Investors use the forward P/E ratio to gauge expectations of future growth and profitability.

Interpreting the P/E Ratio

The P/E ratio is often used as a starting point for analyzing the valuation of a company’s stock. By comparing a company’s P/E ratio to that of its competitors, industry averages, or historical P/E ratios, investors can determine whether the stock is overvalued, undervalued, or fairly priced.

High P/E Ratio: A high P/E ratio indicates that the market has high expectations for the company’s future growth and profitability. Investors may be willing to pay a premium for the stock because they believe the company will continue to generate strong earnings in the future. Companies with high P/E ratios are often growth stocks, meaning they are expected to experience significant growth in the coming years. For example, technology companies or biotech firms that are expected to innovate or expand rapidly may have high P/E ratios, as investors anticipate substantial future earnings.

Low P/E Ratio: A low P/E ratio might suggest that a company is undervalued, or it may indicate that the company is facing challenges in maintaining profitability. Investors might perceive the company’s future prospects as uncertain, or they may believe that the company’s earnings will stagnate or decline. A low P/E ratio can also signal that the stock is out of favor with the market, potentially due to factors such as declining revenue, industry-specific risks, or other negative sentiment surrounding the company.

Average P/E Ratio: A company with a P/E ratio that falls in line with the industry average or its historical P/E ratio is generally considered to be fairly priced. It suggests that the company’s stock price is in line with its earnings and that investors are not expecting significant growth or decline in the company’s future performance.

Factors Influencing the P/E Ratio

Several factors influence the P/E ratio, and understanding these factors is critical when interpreting the ratio in a meaningful way:

Industry Norms: Different industries tend to have different average P/E ratios. Growth-oriented sectors, such as technology, often feature higher P/E ratios due to their strong growth prospects, while more mature or cyclical industries, like utilities or manufacturing, may have lower P/E ratios. As such, it is essential to compare a company’s P/E ratio to others in the same industry to gauge its relative valuation.

Market Sentiment: Investor sentiment can significantly impact a company’s P/E ratio. In bull markets, when investors are optimistic about economic conditions and corporate earnings, P/E ratios tend to rise, as investors are willing to pay more for a company’s stock. Conversely, in bear markets, when investor sentiment is pessimistic, P/E ratios may decline, reflecting more conservative expectations for future earnings.

Earnings Growth: A company’s growth rate is a key factor in determining its P/E ratio. High-growth companies are typically valued at higher P/E ratios because investors expect their earnings to increase rapidly in the future. Conversely, companies with low or declining growth rates may have lower P/E ratios, as investors expect limited growth in their earnings.

Interest Rates: The P/E ratio is also influenced by macroeconomic factors such as interest rates. When interest rates are low, investors may be more inclined to pay higher P/E multiples for stocks, as the return on safer investments (such as bonds) is less attractive. Conversely, when interest rates rise, the opportunity cost of investing in stocks increases, which may lead to lower P/E ratios as investors demand higher returns to compensate for the increased risk.

Company-Specific Factors: A company’s specific circumstances—such as its competitive position, management quality, and financial health—can affect its P/E ratio. Companies with strong competitive advantages, solid management teams, and robust financial performance may command higher P/E ratios, as investors are confident in their ability to generate consistent earnings growth.

Limitations of the P/E Ratio

While the P/E ratio is a widely used and valuable tool in stock market analysis, it has certain limitations that investors should be aware of when using it to assess a company’s value:

Earnings Manipulation: Earnings can be influenced by accounting practices, and in some cases, companies may manipulate their earnings to present a more favorable financial picture. For example, companies may use aggressive revenue recognition techniques or delay expenses to inflate their earnings. As a result, the P/E ratio may not always reflect the true profitability of a company.

Does Not Account for Debt: The P/E ratio does not take a company’s debt into account. Two companies with the same P/E ratio might have very different risk profiles if one has a high level of debt and the other has little to no debt. As a result, investors must consider a company’s debt levels in conjunction with the P/E ratio to assess its overall financial health and risk.

Does Not Reflect Future Performance: The P/E ratio is a snapshot of a company’s current valuation relative to its historical or projected earnings. It does not provide insight into the company’s future growth prospects or potential risks that may arise in the future. For this reason, the P/E ratio should be used in conjunction with other forward-looking metrics, such as the PEG (Price/Earnings to Growth) ratio or discounted cash flow (DCF) analysis.

Vulnerable to Market Sentiment: Because the P/E ratio reflects the market price of a stock, it can be influenced by market sentiment, which may not always align with the company’s intrinsic value. For example, during periods of excessive market optimism or pessimism, P/E ratios can become inflated or depressed, making it difficult to determine a stock’s true value based on the P/E ratio alone.

Comparing Companies Across Different Sectors: Comparing the P/E ratios of companies in different sectors can be misleading, as different industries have different growth expectations and risk profiles. A high P/E ratio in one industry may be considered normal, while in another, it may indicate overvaluation. Therefore, the P/E ratio is most useful when compared within the same industry or sector.

Using the P/E Ratio in Investment Decisions

Despite its limitations, the P/E ratio remains a valuable tool for investors seeking to evaluate the relative value of a company’s stock. To make the most effective use of the P/E ratio, investors should consider the following strategies:

Compare to Industry Averages: The P/E ratio should be compared to the average P/E ratio of companies within the same industry. This helps investors determine whether a stock is overvalued or undervalued relative to its peers.

Examine Historical Trends: Comparing a company’s current P/E ratio to its historical P/E ratios can provide insight into how the market has valued the company over time. Significant changes in the P/E ratio may indicate shifts in investor sentiment or changes in the company’s growth prospects.

Consider Growth Prospects: The P/E ratio should be considered alongside a company’s growth prospects. High-growth companies may justifiably have higher P/E ratios due to their potential for future earnings expansion.

Use in Conjunction with Other Metrics: To gain a fuller understanding of a company’s valuation, the P/E ratio should be used in conjunction with other financial metrics, such as the PEG ratio, return on equity (ROE), or free cash flow.

Assess Market Conditions: Broader market conditions and interest rates can influence P/E ratios, so it is important to understand the economic context when interpreting the P/E ratio.

Example:

Learn how to calculate the P/E ratio with the following example:

Robert Ltd has the following information:
Ordinary shares of $0.50 each: $400,000
10% Preference shares of $0.50 each: $300,000
15% Loan stock $250,000
Net profit after tax $500,000
Ordinary share dividends $45,000
Preference share dividends $30,000
Price per ordinary share $3.54

Then,
Number of ordinary shares = $400,000 / $0.50 = 800,000
EPS = (Net profit – Preferred dividends) / No. of shares outstanding = (500,000 - 30,000) / 800,000 = $0.59
Price Earnings Ratio = Market price per share / Earnings per share = 3.54 / 0.59 = 6 times
This means that the capital value of the share is 6 times higher than the current level of earnings.