What is Price to Earnings (P/E) Ratio?

Fundamentals ·

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There are plenty of useful market indicators which attract the attention of many investors and one of the most popular indicators is price to earnings (P/E) ratio. It shows the relation between the current market price of a security and its earnings per share (EPS).

Illustration

Some sources also call it price multiple or earnings multiple.

How to Calculate Price to Earnings (P/E) Ratio?

As the name suggests the formula is quite simple:

\begin{align} PE = \frac{MP}{EPS} \end{align}

Where:

  • PE: P/E Ratio
  • MP: Current Market Price
  • EPS: Earnings Per Share

It's easy to find the current price, but you also need to find the earnings per share (EPS) value to calculate the P/E ratio, which is a bit more involved:

\begin{align} EPS = \frac{E}{N} \end{align}

Where:

  • EPS: Earnings Per Share
  • E: Total Earnings
  • N: Number of Shares Outstanding

Total earnings are equal to the net profit minus the preferred dividends.

The net profit of a company can be found in its income statement inside its annual report, this information is public for any publicly-traded company. The net profit is basically the total income minus the total expenses.

A hardest thing to do is to find out the preferred dividend, you have to go through 4 more steps to do so, but again, for any publicly traded company, this information should be open to public.

The number of shares on the market is known to everybody as well.

EPS does not include preferred shares, only the common ones. This value tells you a lot by itself, but the P/E ratio can tell you even more.

What Does P/E Ratio Tell Us?

This number shows how much of a company's profit you are indirectly getting for each share you hold. It's a relationship between the current market value of a stock and the fundamental value of its real earnings. Many market participants look only at technical or fundamental analysis but the P/E ratio gives us a tool which stands between two of those worlds which is very helpful.

This ratio shows if a company's stock price is overvalued or undervalued, plus it is useful for a comparison of companies within the same market sector.

How to Interpret P/E Values?

Right now, the average P/E of all American companies is about 22.

This number means that their price is 22 times bigger than their stocks’ earnings per share.

So, for each $22 of the stock price, there is currently just $1 of real earnings per share and it's hard to evaluate it in general because it varies among business sectors. For instance, retail P/E can be quite high (30+) but for an IT sector, those numbers can be completely different so the key is to measure the P/E ratio of a company in relation to its particular industry.

That doesn't mean that the general P/E ratio is useless, the average P/E of 22 is actually quite worrying if we compare it to the historical data and it may mean that the market is dangerously overvalued.

P/E Ratios of Major Companies

Let's take a look at the current P/E ratios of major companies in different sectors:

  • IT, Apple: 16
  • IT, Google: 22
  • IT, Facebook: 28
  • Retail, Walmart: 38
  • Retail, Costco: 33
  • Retail, Kroger: 10
  • Banking, JPMorgan Chase: 11
  • Banking, Bank Of America: 10
  • Banking, Citigroup: 9
  • Oil, Exxon Mobil: 17
  • Oil, Conoco Phillips: 13
  • Oil, Chevron Mobil: 17

As you can see, this ratio tends to be similar within the same industries, but it can vary a lot among different industries.

analytics  ·  business  ·  trading  ·  portfolio  ·  indicators

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