Price-to-Earnings, or P/E ratio, is a headline measure of a company’s value which allows it to be compared to others on a like-for-like basis. It also allows investors to evaluate a company’s value trajectory over time.
You may also hear P/E ratio called “earnings multiple” or “price multiple”, which underscores how this vital indicator is calculated. P/E is arrived at by dividing a company’s current share price by its Earnings Per Share (EPS). The current share price is of course easily found via the company’s stock market ticker, but the latter may take two (or three) different forms.
Trailing EPS looks at performance over the past 12 months and is hence know as TTM (Trailing Twelve Months).
The forward-looking or projected EPS is the really the company’s best guess of how it will do and is usually given in its regular earnings statement before being picked apart by analysts.
A third and slightly less usual way of looking at EPS is to combine the actual and projected numbers from the preceding and forthcoming two quarters.
For pretty obvious reasons, investors often prefer to look at trailing EPS because this deals with objective fact, rather than the state of play the company wishes to project to the markets. They may be overly optimistic or contrariwise pessimistic so that the company can say that it has beaten estimates and so attract positive press. However, as all investors know, past performance is no reliable indicator of the future, and it is very possible to get things wrong by looking in the rear-view mirror only.
Essentially, a P/E ratio tells investors what the market is willing to pay for taking part in a company’s future earnings, and is a very useful indicator of whether a company is over or undervalued relative to likely reality. A high P/E might indicate overvaluation and a low one that company is undervalued (or doing better than it historically has).
A company’s P/E ratio is however only really useful when seen in its broader context. This might be against its own track record, among a peer group of similar organisations either in one market or internationally, or against the stock market index it trades within. For reference, the August P/E ratio of the FTSE All-Share was around 16.6, against a normal range of 12 to 15, depending on market and economic conditions.
Investors need metrics to indicate how much they will need to invest in a company to get £1 of its earnings, and what the market is willing to pay for this participation. Thus, a higher P/E indicates a company at fair to possible overvaluation and a lower one a potential bargain. Depending on market and economic conditions a P/E of around 12 to 15 is considered normal. P/E ratios are very useful indicators, but are by no means the only metric for investors to consider, earnings yield being another important one.