P/E ratio, earnings per share and valuation
- Calculate and interpret a P/E ratio
- Understand why cheap is not the same as good value
- Know other common valuation measures
Price versus profit
The price-to-earnings ratio (P/E) divides the share price by earnings per share. A stock at $60 with EPS of $3 has a P/E of 20: investors pay $20 for each $1 of yearly profit.
Trailing P/E uses the last 12 months of earnings; forward P/E uses analysts’ estimates for the next 12 months, which may turn out wrong.
Why P/Es differ
Investors pay more for companies they expect to grow quickly or that have very reliable profits, and less for slow-growing, cyclical or risky ones.
A high P/E is a bet that growth will arrive. If growth disappoints, both earnings expectations and the P/E itself can fall, which hurts twice.
Cheap is not the same as good value
A low P/E can mean a bargain, or it can mean the market expects profits to shrink. This is the value trap: a stock that looks cheap and keeps getting cheaper because the business is declining.
Compare P/Es within the same industry and against the company’s own history, and always ask why the market is pricing it that way.
Other yardsticks
Price-to-sales helps when a company has little or no profit yet. Price-to-book compares price with equity and is common for banks. Dividend yield is the yearly dividend divided by price.
No single ratio is enough. Valuation is a judgement about the future, and every number is a starting point for questions.
Company A trades at $100 with EPS of $5 (P/E 20) and earnings growing 15% a year. Company B trades at $100 with EPS of $10 (P/E 10) but earnings shrinking 10% a year.
In three years, if those rates hold, A earns about $7.60 per share and B about $7.29. The ‘expensive’ stock may end up cheaper on future earnings, if its growth really happens.
Key terms
- P/E ratio
- Share price divided by earnings per share.
- Trailing P/E
- P/E based on the past 12 months of reported earnings.
- Forward P/E
- P/E based on forecast earnings for the next 12 months.
- Value trap
- A stock that looks cheap but keeps falling because the business is deteriorating.
- Price-to-sales
- Market capitalisation divided by yearly revenue.
- Price-to-book
- Share price divided by equity per share.
- Dividend yield
- Yearly dividends per share divided by the share price.
Find the P/E of two companies in the same industry in VEXA. Write one reason the market might value them differently.
Key takeaways
- P/E = price ÷ EPS: what you pay per dollar of profit.
- High P/Es price in growth; low P/Es can be bargains or traps.
- Compare within industries and over time.
- Use several measures and ask why the market prices it that way.