P/E or Price to Earnings ratio, indicators how much an investor is paying for every 1 unit of earnings the company makes. The P/E ratio is commonly used by investors to determine whether it is favourable or expensive to invest in a company. Ultimately speaking, the ratio illustrates the market value of a company.
High P/E ratio
The higher the stock price, the higher the P/E ratio. Generally speaking a high P/E ratio indicates the stock is expensive that investors would avoid buying until the ratio improves (is lower). The ratio could also become lower if EPS increase with unchanged stock price.
Low P/E ratio
The lower the stock price, the lower the P/E ratio. A company stock is considered cheap if P/E is low, attracting investors to buy into the company. However, a low P/E could also be the result of a highly competitive business sector or a company in distress.
How to Calculate P/E
Price earnings is calculated by dividing stock price with earnings per share: Price / EPS.
Types of P/E ratio
- Forward P/E also known as estimated price to earnings considers current and future earnings. It uses EPS projections that carries the risk of overestimating or underestimating earnings.
- Trailing P/E uses the EPS from the past. Typically earnings from the past 12 months is used to calculate the trailing P/E.
- Absolute P/E uses either EPS of the last 12 months or a combination of two quarters of forward EPS and two-quarters of the past trailing 12 months.
- Relative P/E takes into account the absolute P/E and compares it to P/E values of the past. The time period considered may vary. It could be 10, 20 or even 30 years.
Drawbacks or Limitations of P/E
A company may experience sudden or significant one-time expenditures that could affect the earnings which could be misleading.
The P/E value may be used to compare companies within the same industry or sector but should not be used cross-industry as P/E value can vary greatly per industry.
Estimated earnings for the calculation of P/E ratio includes assumptions about future projections that carries its own risks.