How to read the price to earnings ratio
Within fundamental analysis, two factors often influence the performance of a stock: the earnings a company generates and how investors value those earnings. One common way to gauge the value of a share is the price to earnings multiple, or P/E ratio. This guide explains how to read the price to earnings ratio and where its limits lie. In other words, it covers the components, the analysis, and the warning signs.
What are its components?
To calculate the P/E, an analyst divides the price of a share by the company’s annualized earnings per share. The trailing P/E uses the earnings reported over the last twelve months. In contrast, the forward P/E uses the earnings analysts expect for the next twelve months. Forward estimates can change. Optimism can drive an expansion in the P/E. For example, when perceptions about a company improve, investors may be willing to pay more for each unit of earnings. As a result, the multiple can rise even if earnings stay flat. When expectations turn negative, however, investors may pay less for each unit of earnings, and the P/E can contract.
How to read the price to earnings ratio in practice
First, observe whether the P/E looks high or low against the company’s own history. Many analysts call this absolute valuation. In practice, it means comparing the current P/E with its average over 10, 15 or 20 years. Next, compare the company’s P/E with that of similar companies in the same industry. Analysts call this relative valuation. Of course, the interpretation of the P/E can vary by sector. For instance, some industries carry above-average multiples because investors expect faster growth. Meanwhile, other sectors trade at lower multiples because their businesses are more mature or more cyclical. Historical averages may not repeat, so neither comparison offers a definitive answer.
Why earnings quality matters
The earnings figure in the denominator deserves the same scrutiny as the share price. For example, a one-time gain from an asset sale can inflate earnings for a single year. As a result, the P/E can look unusually low until that gain drops out of the trailing figure. In contrast, a large one-off charge can depress earnings and make the multiple look high. When a company reports a loss, the P/E has no meaningful value. Instead, analysts often turn to other measures in that situation. In practice, it helps to read the notes behind reported earnings. It also helps to check whether the result reflects the ongoing business. Fortunately, many companies disclose unusual items separately, which makes this check easier.
What deserves attention
No single P/E reading leads to an absolute conclusion. Instead, you first need to identify which component, the share price or the earnings, is driving the result. In our view, a high P/E deserves a check that solid fundamentals support it, rather than excessive optimism. In addition, companies with a low P/E call for care. A low multiple can look like an opportunity. In reality, it may reflect a lack of catalysts and little interest among investors.
The P/E multiple can reveal a great deal about how investors perceive a stock. It may help flag potential opportunities, in the form of a cheap valuation, or potential risks, in the form of an expensive one. However, it is only one data point, and a low or high reading does not predict future returns. Therefore, before making any investment decision, investors should pair this valuation analysis with a deep understanding of the business model and the financial situation. Finally, they should also weigh the growth strategy and the experience of the management team. Knowing how to read the price to earnings ratio is a starting point, not a complete analysis.
This article is for educational purposes only and does not constitute investment advice or a recommendation to buy or sell any security.
