Using the Price-Earnings Ratio to Assess Stock Value

The Price-Earnings Ratio is a valuation ratio to measure a company’s current share price against its earnings per-share. Often referred to as the “multiple”, the measure indicates how much investors are paying for each dollar of the company’s earnings. Generally speaking, a high P/E indicates that investors expect the company to achieve higher earnings growth in the future. The P/E ratio is usually compared to companies within the same industry. While there are several different ways to calculate this measure, the Trailing P/E is the most commonly used because it is based on actual company earnings.

Earnings-Based Valuations

Most investors determine the value of a stock through company earnings, which are simply the money remaining after the company pays all its expenses. To arrange for fair comparisons, investors look at earnings of a per-share basis, the EPS. The price/earnings ratio is the best known and most widely-used of earnings-based valuation measure.

Importance of the P/E Ratio

When investors like a company, they will drive up its share price and, by extension, it P/E ratio. Comparing the P/E ratio of that company against its competitors can help determine whether how reasonable that stock is currently priced. A high PE means that company must consistently grow its earnings to meet these investor expectations as falling short of these expectations will cause the stock price to fall.

Price/Earnings Calculations

Trailing P/E is calculated by dividing the current stock price by the company’s earnings per share for the past 12 months. This is the most commonly used P/E measure and, because it is based on actual earnings, it is seen as the most accurate. A trailing P/E is calculated based on the four most recent quarters for the company.

Forward P/E is calculated using forecasted earnings for the company. The forecasted earnings used can either be for the next 12 months or for the next full-year fiscal period. The forward P/E is not seen as reliable as the trailing P/E because it uses estimates for future earnings. It can, however, provide benefit to investors as they work to predict the future performance of a company to determine the worthiness of a stock investment.

Limitations of the P/E Ratio

While P/E ratios offer a quick way to assess value, they should offer you just one data point in making your investment decisions. A P/E that is measured using trailing earnings (which may have been strong) does not necessarily indicate strong future earnings.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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