P/E ratio is the most popular valuation multiple that is used for stock analysis. This ratio shows the price of the stock compared to its earnings. The multiple is so popular because of its simplicity and importance of the net earnings to company.
It is true, that net profit has few serious disadvantages: it is very dependable on the accounting policy and depreciaton, and might be misleading in some cases. That's why it must be used very carefully, and sometimes earnings have to adjusted in the way that would show only normal recurring income. However, this ratio is close to perfect if calculated rightly and carefully.
Price-to-earnings ratio formula:
P/E = share price* / earnings per share**
* It is the last price of the share on the stock exchange.
** EPS, it is net profit for one common share, most often calculated for last four fiscal quarters (trailing earnings) for TTM version.
Simplified calculation (may be applied if there is only one class of shares):
P/E = market capitalization / net profit of the company
* When calculating this ratio, few aspect are needed attention. Currency of the share price and earnings has to coincide. If results in income statement are provided in thousands or millions, you should adjust calculations for that. Net profit (earnings) must be after minority interests.
** One-off incomes or costs have to be eliminated when calculating this multiple.
P/E Ratio Calculator
The ratio may be calculated for different periods:
Current ratio usually is calculated for full year of disclosed financial results. Usually this type of calculation uses the data that is too old to use while financial markets are changing so fast.
Trailing (TTM) is calculated using last four quarters that have been published till the calculation. This version of calculation has the most advantages: uses the most fresh financial results and is unbiased. However, if it is clear that company's results are going to change, forward ratio should be used.
Forward or estimatedratio is calculated for the period of current year or next year using net profit forecasts. This variant of calculation is the best when forecasted profits are accurate, but in the reality forecasts always include some level of bias and uncertainty.
Price to earnings ratio gives information whether the stock is expensive or cheap according to earnings. The lower the ratio is, the cheaper and more attractive the stock should look if ignore other factors. Normally this ratio is in range between 10 and 20, but mostly it depends on company’s growth rate, future perspectives, company’s risk and market conditions:
The growth of earnings is a key factor for P/E multiple. The higher is the growth the higher should be the multiple (which means that stock is more expensive). Investors care about future's earnings but not the earnings of the past. That is why 'forward' version is often used which uses forecasted earnings for future periods (even few years in forward).
The risk of a stock is another important factor that has affect to the valuation of stocks. The higher the risk of a stock is, the lower shouldthis multiple be (of course, if other conditions are the same).
Risk free rate has huge affect to overall investment market. When interest rate increases, it has negative effect to the stock market and stock valuation decreases which makes this financial ratio to decreae together with stock prices.
Attitude to the risk in the markets which is reflected by volatility is another huge factor to the relative value of stocks. During some financial turmoil, investors starts to remember about the fear. They start to search for safe investments and are avoiding risky ones, so it is natural that values of stocks are decreasing together with risk tolerance.
When you are comparing P/E multiple to the same multiple of other companies, the main condition is that those companies would have identical business model in the same (or comparable) niche. And remember, that it is very important to make sure that earnings are sustainable and were not affected by some short-middle term factors.
If you want to find cheap stocks that would be good investments, you can’t rely on one ratio. You have to calculate more valuation multiples.
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