June 06, 2023

Understanding the P/E Ratio

Within fundamental analysis, there are two key factors that influence the yield of a share: the earnings generated by the company and how investors value those earnings. In this context, one way to determine the value of a share is through a financial ratio known as the Price/Earnings multiple (P/E ratio). In this tutorial, we will detail the most relevant points surrounding this useful metric:

What are its components? The P/E is calculated by dividing the price of a share (“Price”) by a company’s annualized earnings per share (“EPS”). The P/E can be constructed with the known earnings over the last twelve months (Trailing P/E) or with the expected earnings for the next 12 months (Forward P/E). In this sense, optimism can lead to an expansion in the P/E, being a period in which perceptions about a company improve and, as a result, investors are willing to pay more for each unit of earnings. On the contrary, when investors’ expectations are negative, they will seek to pay less for each unit of earnings, causing a contraction in the P/E.

How to analyze the P/E? Firstly, it is necessary to observe whether the P/E value is “high” or “low”, to eventually determine an absolute valuation, which is nothing more than comparing the current P/E with its historical average (10, 15, 20 years). To complement the analysis, the company’s current P/E should be compared with that of similar companies or companies in the same industry, in what is known as relative valuation. It is important to keep in mind that the interpretation of P/E can vary; where some industries have higher than average P/E multiples due to their growth potential, while other sectors may have lower P/E multiples due to the more mature or cyclical nature of their businesses.

What to pay attention to about P/E? There is no absolute conclusion because it is necessary to analyze which of its two components (share price or earnings) is the one that is predominating. However, it is important to make sure that a “high” P/E is based on good fundamentals and not on excessive optimism.  Likewise, attention should be paid to those companies that have a “low” P/E, which could be misleadingly interpreted as an opportunity, when in fact, it reflects a lack of catalysts and little interest among investors.

Finally, the P/E multiple can tell us a lot about the general perception that investors have of a share, being a tool that helps to detect opportunities (cheap valuation) or potential risks (expensive valuation). However, before making a conclusion about a company for the purpose of an investment decision, this valuation analysis must be complemented by a thorough understanding of the business model, financial situation, growth strategy and experience of the management team.