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What are Price-to-Earings (PE) Ratios?

The price-to-earnings ratio, or PE ratio, is one of the most widely used methods of valuing a company’s stock. It is used by analysts, investors and traders to help determine whether a company is being fairly valued by the market, relative to its peers. However, it is by no means a fool-proof measure and should be used in conjunction with other measures of valuation and broader research.

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The PE ratio explained

The PE ratio is determined by dividing the company’s stock price by its earnings per share, with the resulting figure being the number of years it will take for the business to earn its current price. Here’s an example:

Company X’s stock price is currently $40. The company has 100 million shares on issue and last year had earnings before interest and tax (EBIT) of $200 million, or $2 per share. Dividing 40 by 2 gives us a price-to earnings ratio (also called a “multiple) of 20, meaning it would take 20 years for the company to earn back its valuation at current levels. A trader or investor can then compare company X’s PE ratio with that of other companies to see whether it is fairly valued at present or not. The ratio can also be used across an entire index, such as the S&P 500.

Calculating the ratio

There are two ways of calculating the ratio:

Trailing PE Ratio

This number uses the businesses most recent earnings, taken from company reports.

Forward PE ratio
The forward PE ratio is based on analyst’s projections of a company’s earnings for the year ahead. For instance, if the consensus estimate among analysts was for company X to grow its earnings per share 10% this year to $2.20, its PE ratio falls to 18.18.

What are the benefits of the PE ratio?

Arguably the strongest feature of the PE ratio is that it provides a relatively simple way to compare the valuations of different stocks: you don’t need to be an expert trader to know that a lower PE ratio is preferably to a higher one, all things being equal.

Its major shortcoming, however, is that it’s too simple to be used in isolation. A PE ratio will not tell you how fast a company’s earnings are rising or falling, nor does it tell us anything about a company’s revenue, how much debt it is carrying or whether it is winning or losing market share. This is all-important information that a canny investor would want to know before making a decision to buy or short the stock.

How to use a PE ratio when trading

Price to earnings ratios are really only useful for apples-to-apples comparisons, for instance, if General Motors has a ratio of 14 and Ford has a ratio of 18, that’s an indication GM’s stock may be undervalued, or that Ford’s is overvalued. Armed with that information, a trader and investor may form a view about where each stock is heading: is GM due for a rally? Or is Ford’s stock likely to tank?

However, it is also perfectly possible that the divergence in the two company’s ratios is justifiable, which is why more research is needed before making a decision to invest or trade. For instance, Ford’s earnings may be growing, while GM’s may be stagnating or going backwards.

Is there such a thing as a good PE ratio?

In a word, no: it’s all relative. A company that is growing its earnings quickly deserves a higher multiple than one that is stagnating or growing slowly. That’s why it makes little sense to compare the PE ratio of a tech company with that of a banking stock.

Other ways to value stocks

The PE ratio is a good place to start when comparing the valuations of different companies, but there are numerous other methods investors should be aware of. Here are a few other ways to value stocks:

Price/earnings-to-growth (PEG) ratio
The PEG ratio measures a company’s existing PE ratio against the expected growth in its earnings. To calculate this, divide the PE ratio by the rate of growth.
Using the Company X example (a PE ratio of 20, divided by 10% earnings growth) gives us a PEG ratio of 2. As a rule of thumb, analysts usually consider a stock with a PEG ratio of less than 1 to be undervalued.

Price-to-sales/revenue ratio
To determine a stock’s price to sales ratio, investors and traders divide a company’s market value (its share price multiplied by the number of shares on issue) by the value of its revenue or sales over the past year. This is a popular way to value “growth” stocks, especially in the tech space, where sales often grow faster than earnings in the early years. It is also useful in valuing companies that have negative earnings.

Price-to-book (P/B) ratio
The P/B ratio is calculated by dividing a company’s market valuation by its book value – which can be worked out by dividing a company’s market value per share by the value of its assets per share (minus debt). This can be useful when comparing the value of similar companies with similar growth profiles. A P/B  ratio of less than one means a company is worth less than the value of its assets, which can be a sign that it is undervalued, but also that the company is in trouble. This metric is especially popular among so-called value investors like Warren Buffett.

Is the PE ratio a good way to value stocks?

The PE ratio is an extremely useful tool for valuing companies, but it shouldn’t be the only item in a trader or investors tool kit. It should be considered alongside other means of valuation, as well as broader research into the company’s performance and prospects.

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