Work out the price-to-earnings ratio and explain what it means
The idea
The price-to-earnings ratio is price per share over earnings per share — what the market pays for a unit of current profit. Trailing P/E uses reported earnings and is factual but backward-looking; forward P/E uses a forecast and is relevant but only as good as the forecast. A high P/E is not by itself expensive: it can mean growth is expected, or that earnings are temporarily depressed, and the second case is why P/E becomes meaningless as earnings approach zero and undefined when they are negative. Multiples are comparisons, so they only mean anything against a peer, a history or a justified value derived from expected growth and required return.
Formulas
Price-to-earnings ratio
price-to-earnings = price per share ÷ earnings per share
- price per share
- the current market price
- earnings per share
- the last four quarters for a trailing ratio, the next four for a leading one
Trailing and leading multiples are not comparable with each other. Negative earnings make the ratio meaningless rather than low, which is the usual reason to reach for a different multiple.
Justified leading price-to-earnings
justified leading price-to-earnings = payout ratio ÷ (r − g)
- payout ratio
- the share of earnings paid out as dividends
- r
- the required return on the equity
- g
- the sustainable growth rate
The Gordon model divided through by earnings, so it says what multiple the fundamentals justify rather than what the market is paying. The gap between the two is the argument for buying or not.
A practice question
The price-to-earnings ratio is price per share divided by:
- earnings per share — correct
- book value per shareWhy not: That gives price-to-book, a multiple of what the company holds rather than of what it earns.
- dividends per shareWhy not: That is the inverse of the dividend yield, and it reflects the payout decision rather than the profit itself.
It expresses what the market pays for one unit of the firm's current profit.
A harder one
A high price-to-earnings ratio may indicate expected growth, or that current earnings are:
- unusually highWhy not: Unusually high earnings make the denominator large, which pushes the multiple down rather than up.
- temporarily depressed — correct
- exactly at trendWhy not: At trend the multiple carries no distortion at all, so it cannot be the explanation for an unusually high one.
A cyclical trough inflates the multiple without anyone being optimistic, which is the common trap.
The hardest tier
Two firms have identical price-to-earnings ratios but different expected growth. The one with faster growth is:
- more expensive on a growth-adjusted basisWhy not: Reverses the comparison. Paying the same multiple for more future earnings is the cheaper of the two.
- identically valuedWhy not: Identical on the raw multiple, but the multiple says nothing about growth, which is exactly what the adjustment brings in.
- relatively cheaper on a growth-adjusted basis — correct
Paying the same multiple for a faster-growing profit stream is the better deal, which is the idea behind PEG.
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