Here’s what is the Price to Earnings Ratio (P/E Ratio) and 4 key ways investors can use it to their advantage!

What is the Price to Earnings Ratio or the P/E ratio? The P/E ratio is the most used multiple of all those used in relative valuation to compare companies. It is what analysts and journalists are talking about when they say ‘This ASX company is trading at _ times earnings’. But how does it work and how important is it in making investment decisions?

What is the Price to Earnings Ratio (P/E Ratio)?

Price-to-Earnings (P/E) Ratio is a financial metric used to evaluate the valuation of a company’s stock. It is calculated by dividing the market price per share by the earnings per share (EPS). Earnings per share is essentially net profit (or net income) divided by the number of shares on issue. Theoretically, this should flow through to the shareholders, although virtually no company (barring REITs because these entities only exist to pay dividends to shareholders from property investments) pays out 100% of its net profit.

So if a company records EPS of 20c per share and has a share price of $4, it is trading at a multiple of 20x. This may sound like no big deal when used in isolation, but investors use this metric to compare a company to others.

How the P/E multiple is used

An investor may say for instance,’ Company A is trading at 20x earnings but it only has a 10% margin while Company B is trading at 10x earnings but has a 40% profit margin and so Company B is better to buy’.

This is an oversimplified example, we concede. After all, these companies may be in different industries – Company A may have a high margin for its industry while Company B may have a low margin for its industry. But we hope you ​have understood what we are trying to illustrate.

The P/E ratio is easy to calculate and understand for several reasons, particularly because it is simple and intuitive. It provides a quick snapshot of how a company’s stock price relates to its earnings. Although it may not be useful for companies in different industries, the above example we used may be more useful if those companies were in the same industry, and so investors do use this multiple to compare companies.

Alternatively, they may just compare one company’s multiple to the average of all in a certain index, such as the ASX 200 or S&P 500. For these and many other reasons, the P/E ratio is widely used and accepted among investors, analysts, and financial professionals.

What are the drawbacks?

On the flip side, there are some disadvantages. Most notably, the P/E ratio does not consider the growth rates of earnings. Two companies with the same P/E ratio might have very different growth prospects. A way to work around this is to use the PEG multiple which we’ve written about here.

Other reasons include that P/E does not account for debt levels and the reality that earnings can (and may in some instances) be manipulated through accounting practices, which can distort the P/E ratio. Also keep in mind P/E is based on past earnings, which may not always accurately reflect future performance.

4 Ways Investors can use P/E to their Advantage

Acknowledging the limitations that we noted above, we think there are some instances where P/E can be used. First, as we’ve already noted, investors can and do compare the P/E ratios of companies within the same industry to identify potential investment opportunities. A lower P/E ratio might indicate an undervalued stock, while a higher P/E could signal overvaluation.

Second, investors can also use the P/E ratio to distinguish between growth and value stocks. Growth stocks typically have higher P/E ratios due to anticipated future earnings growth, while value stocks have lower P/E ratio and might be undervalued.

Third, P/E can provide insight into market sentiment. A very high P/E ratio might indicate overly optimistic expectations, while a very low P/E could suggest pessimism or an overlooked opportunity.

And finally on our list (but by no means the only ways this multiple can be used), comparing a company’s current ratio to its historical ratios can help investors assess whether the stock is currently overvalued or undervalued.

Conclusion

The P/E ratio is a fundamental metric that offers investors a quick way to evaluate the valuation of a company’s stock relative to its earnings. While it has several advantages, such as simplicity and ease of comparison, it also has notable limitations, including its backward-looking nature and potential for earnings manipulation. Investors can use the P/E ratio effectively by combining it with other financial analyses and considering industry-specific factors to make well-rounded investment decisions.

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