Valuation Evaluation Using Price-Earnings Relatives

by Wayne A. Thorp

The price-earnings ratio (P/E)—or earnings multiple—is one of the most popular measures of company value. It is the current stock price divided by earnings per share for the most recent 12 months.

The popularity of the price-earnings ratio stems from how it relates the market’s expectation of future company performance—embedded in the price component of the equation—to a company’s actual recent earnings performance. The greater those expectations, the higher a multiple of current earnings investors are willing to pay for the promise of future earnings.

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But price-earnings ratios are not across-the-board comparable in terms of value. How, then, do you judge whether a company’s price-earnings ratio represents good value?

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