Will the Real P/E Please Stand Up?

Will The Real P/E Please Stand Up? Splash image
In the world of investing, no one piece of financial information tells all. But the price-earnings ratio comes close, containing a wealth of information about the market's expectations for earnings growth.

However, if you look through any investment information resource commonly used by individual investors, you'll find numerous definitions of the term. Because the price-earnings ratio is a powerful summary of market opinion, financial analysts have frequently fiddled with it, producing what may appear to be endless variations on a theme.

Sorting out the different ways price-earnings ratios are quoted and how each different price-earnings ratio technique can be applied and interpreted should aid in your stock selection decisions.

What It Is

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Price-earnings ratios (P/Es) are determined by taking a stock's share price and dividing it by the firm's earnings per share.

The ratio simply relates share price to earnings: the higher the price-earnings ratio, the more investors are paying for each dollar of earnings. If a stock has a price-earnings ratio of 15, it means that investors are paying $15 for each $1 of earnings.

Other terms for price-earnings ratios are: earnings multiple and price multiple.

The variations on price-earnings ratios occur with the decisions as to what share price to use (current, average, etc.) and which earnings figure to use (trailing 12 months, expected earnings, etc.).

How It Can Be Used

Price-earnings ratios are most commonly used to value future earnings.

In general, the higher the price-earnings ratio (relative to either its historical ratio, an industry ratio or the market ratio) the more the market is confident that earnings will grow in the future.

Low price-earnings ratios reflect expectations of lower growth and greater uncertainty.

All investors should be interested in finding firms that have a high, certain earnings growth rate and a relatively low price-earnings ratio. However, if the market agreed with your estimate of high growth, the price-earnings ratio would not be relatively low; rather, it would be either average, or perhaps even relatively high.

In order to form a judgment as to whether earnings are overvalued, undervalued or fairly valued using P/Es, you must judge whether you agree with the market's opinion regarding the firm's growth prospects.

How It Can Be Misused

A simple price-earnings ratio does not convey on its own all the information you need. Instead, it needs to be judged relative to other P/Es—by comparing a firm's current price-earnings ratio, for instance, to its historical P/E, the industry average P/E or the market P/E.

Since earnings are in the denominator of the calculation, price-earnings ratios are not useful if the firm is not generating earnings (you cannot divide by 0), or if it has negative earnings (the resulting negative multiple is meaningless).

One-time events may also push price-earnings ratios up or down. Special charges or the sale of assets may lead to reported earnings that are below or above their normal levels. As long as the market interprets the earnings deviation as being only a temporary phenomenon, the abnormal P/E will be discounted by the market.

In addition, reported earnings themselves are subject to many assumptions and judgments, so if you are using price-earnings ratios, you must make sure that you understand the quality of the underlying earnings number.

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P/E Variations

There are an endless variety of price-earnings ratio calculations. Here are the most common, along with how they can be applied and interpreted.

P/E Trailing Earnings

P/E trailing earnings is calculated using the most recent 12 months of reported earnings. This would give the most current actual earnings figure, but since earnings are reported quarterly, the trailing earnings could be over three months old.

P/E Current Earnings

P/E current earnings, used primarily by Value Line, steps into the future while straddling the past. The earnings used in the denominator are the most recent two quarters of earnings plus the estimated earnings per share for the next two quarters.

A common stock's price today is based on expectations of future performance, a forward-looking valuation. Relating price to estimated earnings measures value today relative to expectations, and can serve as a guide as to whether a stock is relatively over- or undervalued.

P/E Forward (or Estimated) Earnings

P/E forward earnings uses estimates of annual earnings for the fiscal year in the denominator. An analyst's forecast or a consensus of analysts is used.

At the beginning of the year, a price-earnings ratio using estimated earnings is completely forward looking, but as the year-end nears, more of the estimate is based on actual earnings and less is a forecast. Earnings estimates for the year are revised as new information is released and quarterly earnings become available.

P/E Average Price

P/E average price divides the average market price of the common stock for the fiscal year by the earnings per share for the fiscal year.

This approach attempts to smooth out the price-earnings ratio by reducing the day-to-day variation in ratios caused by stock price movements that may have been the result of general volatility in the stock market.

P/E Median

P/E median is the mid-value of a series of annual price-earnings ratios, ranked in ascending or descending order. The median is more useful than the average because the median, unlike the average, is not distorted by extreme values. The median of historical price-earnings ratios is valuable for gauging the current price-earnings ratio versus some historical norm.

P/E Normalized

P/E normalized is designed to derive a base, or normal, price-earnings ratio. It is similar in purpose to the forward price-earnings ratio, but with the further adjustment of using the following year's actual earnings.

This approach is valuable because examining the history of price-earnings ratios using trailing or fiscal-year earnings does not capture the expectational component of the price-earnings ratio.

A normalized price-earnings ratio goes back in time and divides the previous year-end price, or the high or low (or both) for the year, by the following year's actual earnings per share. These normalized price-earnings ratios can then be averaged.

Rather than looking at today's price and earnings and determining whether the price-earnings ratio is relatively high or low, many analysts would suggest looking at today's price and next year's estimated earnings, so that the price-earnings ratio is based on estimated earnings.

The normalized price-earnings ratio makes the adjustment with actual, rather than estimated, earnings.

P/E Relative

P/E relative allows comparison of the price-earnings ratio of a firm to the price-earnings ratio of the overall market, currently and historically.

By dividing the firm's price-earnings ratio by the market's price-earnings ratio, P/E relative is determined. Often the Standard & Poor's 500 is used as a proxy for the market. Prices and earnings for the firm and the market should reflect the same period.

Looking at these figures historically would generate median and average P/E relative figures for comparison to the current P/E relative. The P/E relative is much like relative strength measures, which relate the change in a stock's price to the change in value of a market index.

A P/E relative can also be calculated using industry price-earnings ratio data instead of the S&P 500, if it is available.

P/E Definitions

P/E Trailing Earnings
Most recent market price per share divided by most recent 12 months (four quarters) of reported earnings per share.

P/E Current Earnings
Most recent market price per share divided by most recent two quarters of earnings per share plus estimated earnings per share for the next two quarters.

P/E Forward (or Estimated) Earnings
Most recent market price per share divided by an analyst's forecast or a consensus of analysts' forecasts of earnings per share for the fiscal year.

P/E Average Price
Average market price per share for the fiscal year divided by earnings per share for the fiscal year.

P/E Median
Mid-value price-earnings ratio of a series of annual price-earnings ratios ranked in ascending or descending order.

P/E Normalized
A historical price-earnings ratio: the previous year-end market price per share divided by the following year's actual earnings per share.

P/E Relative
The firm's price-earnings ratio divided by the market's price-earnings ratio. The S&P 500 is often used as a proxy for the market.


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