WHAT IS THE P/E RATIO?

The P/E ratio tells us how much investors are willing to pay for $1 dollar of a company’s earnings, and reflects investor’s expectations of future earnings growth. 

For example, if a company has a share price of $100 and earnings of $5, it has a P/E of 20. This tells us that the shares of this company are currently trading for 20x its current earnings. By itself, this number doesn’t tell us a lot, as it needs to be compared to the company’s historical P/E range, the industry average, as well as the company’s future growth prospects to get a better sense if that multiple seems justified to pay for the company today. 

In general, a higher P/E ratio suggests that investors are expecting higher earnings growth in the future. 

Another way to look at this ratio is by inverting it. When inverted, this ratio is called the earnings yield which tells us the expected return for every dollar invested in the company. 

Earnings Yield = Earnings Per Share (EPS) / Share Price

Using the same example, a company with a P/E of 20, would have an earnings yield of 1/20 = 5%. 

This can be a useful tool for comparing potential returns between investments. The higher the P/E, the lower the earnings yield will be.

P/E RATIO FORMULA AND CALCULATION

A company’s P/E can be estimated on a trailing or forward basis. 

The trailing P/E ratio is found by taking the current share price of a stock and dividing it by the company’s reported EPS for the last 12 months (also referred to as trailing 12 month earnings). 

Trailing P/E Ratio = Current Share Price / Historical EPS

However, the trailing P/E also has its drawbacks, particularly during an economic contraction when a company’s earnings are under pressure. During this time, the earnings of a company typically decline, and as a result, the valuation may actually rise if the stock price doesn’t adjust down by the same amount. 

Second, because the trailing P/E is based on historical earnings, sometimes it is not reasonable to expect that will continue into the future.

WHAT IS FORWARD P/E RATIO?

The forward P/E ratio is calculated as the current share price divided by the projected earnings per share for the next 12 months. These earnings forecasts are typically provided by analysts and based on their estimated EPS over the next 12 months. 

Forward P/E Ratio = Current Share Price / Forecasted EPS

Generally, investors tend to focus more on the trailing P/E because it is what the company has actually earned. Whereas, the forward P/E uses estimates of future earnings that come from analysts which historically, have been shown to be optimistic, especially when estimating quarterly results. This can lead to the forward P/E being understated at times, particularly if analysts are overestimating EPS growth for the company. 

If the forward P/E ratio for a company is higher than the trailing P/E, this means that the company is expected to have higher growth in EPS over the next 12 months compared to the previous 12 months. 

Looking at a real life example: Google stock is currently trading at a trailing P/E of 23.8 while its forward P/E is 17.7. Within the last 5 years, Google has traded within a P/E range of 15.5 – 54.5. The industry average P/E for similar companies is 26.2. The S&P 500 average P/E is 23.7.

The current P/E for Google tells us that the market is currently willing to pay 23.8x Google’s current earnings to buy a share in the company. We can also see that Google is currently trading for a slight discount to the industry average of 26.2x and is trading in the mid range of its own 5-year history. 

The next thing to look at is the growth rate expected in EPS going forward, as one reason as to why Google may be trading at a discount to the industry average and lower than it’s traded in previous years, is because the market expects its future earnings growth to slow going forward, thereby justifying a lower multiple.  

Using our TIP Finance tool, I can see that Google’s past 5 year average EPS was 38.12%, so the market may be pricing in their earnings growth to slow, which means that Google wouldn’t warrant as high of a multiple as it once did when it was growing at such high rates. This suspicion is confirmed when looking at Google’s current estimate for the next 5-year growth in EPS of 16.3%, much lower than the past 5 years rate of 38.12%. 

I also like to compare the forward P/E to the current P/E to get a sense of analysts’ next year estimates of growth in EPS and see if that seems reasonable. Because Google’s forward P/E is less than its current P/E, (17.7x vs 23.8x) this means that analysts forecast next year’s EPS growth to be greater than the previous year. This checks out as analysts are currently expecting growth in EPS over the next year to be 19.8%, while growth over the past year was -18.6%. 

These are just some of the ways I incorporate using the P/E multiples as a tool in my valuation analysis when assessing a stock. Another important piece to consider is where that multiple may be in the future, as you will need to apply a future multiple when performing your intrinsic value analysis of a stock and you will need to have some estimate of what that future multiple may be. 

In general, while it’s impossible to predict where a future price multiple will be, history shows that price multiples tend to mean revert over time. This means that if you are paying a premium multiple for a company, one that is well above its industry average and within the high range of its own history, then you should expect that as the company matures over time, that multiple will also have to come down to a more average range. 

In the case of Google, where it is currently trading slightly below the industry average, this stock may actually benefit from a bit of multiple expansion over time if their EPS growth were to pick up in the future. 

If you are stuck on what multiple and growth rates to use, I highly recommend checking out Aswath Damodaran as he publishes these data sets on his website.

HOW CAN YOU USE THE P/E RATIO?

The P/E ratio is a useful tool in valuation analysis as it helps us compare the relative valuation of a company and tells us the market’s expectations of future growth of a stock. However, the P/E ratio alone does not tell us whether a stock is over or undervalued. An investor must perform a discounted cash flow or some type of intrinsic value analysis to get an estimate of what the company is worth to determine if the company is over/undervalued.

Just because a company is trading for a higher P/E relative to its peer group and own history does not necessarily mean it’s overvalued, if that price is justified. 

For example, a high P/E ratio may indicate that investors are optimistic about a company’s future earnings potential, such is the case with Tesla, which trades at 47.5x earnings compared to the industry multiple which is around 10.3x earnings. This high multiple tells us that the market expects Tesla’s future growth to far outpace the industry average of other automakers, and because of that, market participants are willing to pay a hefty premium for these shares and this future growth prospect. 

To confirm this, the current next year growth estimate for Tesla’s EPS is 42.5%, compared to the industry average of 16%. This tells us that the market is pricing Tesla at a premium based on the expectation that it will deliver strong (and above industry average) growth in the future. 

Again, just looking at the P/E alone won’t tell us whether Tesla is overvalued or undervalued at today’s price. To determine if Tesla stock is overvalued at this price, an investor needs to come to an estimate of the intrinsic value of the stock.

 If you are a beginner investor, I highly recommend checking our Ultimate Stock Investing Guide for Beginners as a good place to start.

FREQUENTLY ASKED QUESTIONS ABOUT P/E RATIO