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Ratio Analysis: The Price-Earnings Ratio

The price-earnings ratio is the second major valuation ratio profiled in Axel Tracy's book, Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet.

The first was earnings per share or EPS. As noted in our digest of that ratio, knowing the EPS is helpful but incomplete knowledge, since it does not factor in the share price. If earnings per share are $1, that would be an excellent return on a $5 stock but a disappointing return on a $20 stock.


That's where the price-earnings ratio (also called "price multiple" or "earnings multiple") helps investors. As the name suggests, it lays out the relationship between the price of a share and the earnings of each share.

In Tracy's words, "Since earnings and EPS is closely linked to stock price value, the P/E Ratio can be regarded as a measure of value (cheap or expensive) because in theory it measures how much investors are willing to pay for a given level of EPS, i.e. "this stock is cheap because I only have to pay 4 times its EPS" or "this stock is expensive because I am paying 50 times its EPS"."

While there are different opinions on the usefulness of the price-earnings ratio, there's no doubting its popularity. It figures prominently within the investment community and in media coverage of the relative valuations of various markets.

When used this way, the ratio becomes a barometer for the cheapness or expensiveness of markets, not just stocks. Investors and analysts who follow the short-term gyrations of the market will tell us that a market such as the New York Stock Exchange or Nasdaq is getting more or less expensive based on the price-earnings ratio of all its component companies.

It is easy to calculate the formula:


Price/Earnings (P/E) Ratio = Stock Price / Earnings per Share



For example, if the stock price is $100 and the earnings per share are $7.50, then the Price/Earnings ratio is 13.33 ($100 / $7.50). To determine numbers for the calculation, get the stock price from your broker or any reporting service, while the earnings per share number can be calculated using information from quarterly or annual reports, from the financial statements or from a reporting service.

GuruFocus provides the price-earnings ratio, plus a couple of variations. The ratio number is found at the top of the Ratios section on a stock's Summary page; below is a screenshot of the GuruFocus Ratios section for United Parcel Service (NYSE:UPS):

Immediately to the right of the label, "PE Ratio," is the ratio value itself. Is 21.62 a good ratio, a bad one, or something else? The colored bars to the right of the number provide a couple of clues. The first colored bar shows how 21.62 compares to the price-earnings ratios of peer companies. The reddish hue indicates UPS compares unfavorably. Under the "Vs History" column, it shows how the current price-earnings compares to the ratio's history for that company. The green color shows it compares favorably to its ratio in the past.

Just below it is the "Forward PE", a name that captures the forward-looking nature of this metric. It is an estimate price-earnings ratio based on the projected earnings of the next 12 months, or the next full fiscal year.

Third, we see "PE Ratio without NRI", which stands for a price-earnings ratio that does not include non-recurring income (something such as the sale of a major asset). In most cases, investors want to know the regular operating income, since non-recurring items can paint a misleading picture.

Getting back to the regular price-earnings ratio, the number also tells us how many years of earnings it will take to match the stock price. From another perspective, it shows how much an investor would have to pay to buy the earnings of a stock.

Each time the price of the stock changes or the earnings change, the price-earnings ratio will change, too. In turn, the stock price is determined by investor preferences as well as economic conditions. On the other hand, changes in earnings reflect what management has done well or done poorly. To some extent, economic conditions can make a difference in management's performance, too.

Turning to the drawbacks of using the price-earnings ratio, Tracy noted that it is best used within industries to compare one company with another company in the same industry. Some industries, he noted, have naturally higher price-earnings ratios than other industries. Of course, industry averages can be computed and the companies within it compared with each other, and averages per industry can be compared with each other.

The other significant drawback is that the ratio may not tell you whether a stock is expensive or cheap. He added,


For the original assumption to hold then you must expect that a 'cheap' stock will eventually rise to fair value and an 'expensive' stock will eventually fall. As one of my investment idols said: you may be comparing a 'cheap' 4-cylinder hatchback car, to an 'expensive' V8 racecar. The racecar will always be a better car, always perform better and always win the race. Just because you bought the 'cheap' car doesn't mean its performance will rise to a fair, average level in the future and catch up to the racecar. After all, there may be a very valid reason why it was so cheap.



Conclusion

The price-earnings ratio is one of the best known and most commonly cited ratios. It is a valuation ratio, meaning it is designed to help investors determine whether the price of a stock is high, low or somewhere in between.

It is calculated by dividing the stock price by a year's earnings, whether in the past or in the future (forward P/E). It is also applied to industries and whole markets to give investors a comparative sense of their health.

By itself, though, it is not enough on which to make a buy/sell decision. A low price-earnings ratio may reflect either a market that doesn't realize the value of a stock or a company that is financially unwell.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.