Understanding the PE Ratio Formula and Why It’s Such a Popular Stock Metric

If there’s one stock evaluation metric that people love to throw around, it’s definitely the old staple: the PE ratio.  Just open up any money magazine or financial article, and this will usually be one of the first values that they highlight.  But even though there’s really not much to the PE ratio formula, its importance is warranted because it can reveal a lot about the company and investors belief about its future.

Dissecting the PE Ratio Formula:

The technical definition of the PE ratio formula is as follows:

P/E Ratio = Price of a Share / Earnings per Share

Just to let you know, the PE ratio is often written as “P/E ratio” or just “P/E”.  It is also sometimes called the “price multiple” or “earnings multiple”.

Let’s do a quick example using the stock for AT&T:

According to this screen shot from Yahoo Finance:

• Current Price = $35.68
• Earnings per Share (EPS) = $1.29
• Therefore, the P/E = $35.68 / $1.29 = ~27.66 (this does not match the number given on Yahoo exactly due to rounding of significant figures)

Remember that the price of a stock changes every minute as investor demand and supply dictates its increase and decrease in value.

The earnings portion of the equation tends to remain for static and can be based on one of the following:

• Trailing PE: Uses the recorded earnings per share from the last four quarters.  This is the way that the P/E ratio is most commonly reported and what you find in most financial articles.
• Forward PE: Uses the expected earnings per share from the upcoming next four quarters based on analyst and company predictions.
• Current PE: Uses a combo of the past two quarters and expected two quarters EPS.

A side-note on earnings: Companies can use different accounting methods and tax rules to manipulate their earnings.  Just be aware that sometimes you may not always be comparing apples to apples when it comes to earnings reports.

What Does the P/E Ratio Mean?

So why the love for this metric specifically?  Investors can use the PE ratio as a way to gauge the appreciation in value for the shares of a company.  A high or low number can reveal whether a company is currently under-valued or over-valued.

Let’s think of it this way:

The “Selling My Blog” Example:

Suppose my blog My Money Design became its own company.  And let’s say this blog was making $10,000 per year.  Now suppose you offered $50,000 to buy it.

That would be a PE Ratio = $50K / $10K = 5.0

So what if I had asked a price of $100,000 to buy my blog?

That would be a PE Ratio = $100K / $10K = 10.0

Which would you rather spend: $50K or $100K?  That’s the difference between in PE ratio formula of 5.0 and 10.0.

So in this instance, a lower PE ratio would look more attractive.  But is this always the case?

I’m afraid not.  Remember that a price becomes the price only when someone is willing to buy it for that amount.  I cannot emphasize this enough; and not just in personal finance.

Suppose I really wanted $100K for my blog but all I was able to get was $50K.  That would mean that potential buyers may not have a lot of optimism about the future of my blog.  Likewise, if someone was willing to give me $100K no problem, then perhaps that buyer does have a lot of confidence in the future of my blog and its ability to make earnings.  So in this case, a higher PE ration would look more attractive.

AT&T Example Again:

Let’s go back to our AT&T stock example and use a real company to see how this works.

T has a P/E of 27.5.  In general that sounds kind of high.  So why is that?

Its current EPS is $1.29.  If we fast-forward one year, we’ll see that the expected EPS is equal to $2.51.  So as you can guess, the price is high because investors are expecting to have an increase in EPS over the course of the year.  That investor confidence fuels a higher price which then goes through the PE ratio formula to yield a higher number.

Notice that the forward P/E is lower than it is now at 13.17.  Should you be worried?  No, this shows that if the price of the stock stayed exactly the same as it is now, then the P/E value would be lower since the earnings would be higher.  Do you really think the price will stay the same a year from now?  That’s incredibly doubtful.  The reason companies even publish this value is to demonstrate to investors that there might be a good opportunity to buy.

What’s a Good PE Ratio?

That’s a loaded question …

Probably the most value from looking at the PE ratio comes from comparing stocks against their own historical data or with other stocks inside the same industry.  For example: Comparing the PE ratios of a stock from Communication versus Technology would not gain the most value.

To give you some idea of where to start, the historical PE ratio of the median stock in the S&P 500 Index is approximately equal to 15.

Conclusions:

So to sum everything up, here’s what the PE ratio formula can tell us:

A high P/E Ratio can indicate that:

• Investors are expecting higher earnings growth in the future.
• The price may be driven up too high and the company may be over-valued.
• Sellers are holding out longer and not releasing as many shares into the market.
• Earnings for this company may be higher than normally, and it may possibly be hard to keep up with or sustain.

A low P/E Ratio can indicate that:

• Investors are expecting lower earnings growth in the future.
• The company may be under-valued due to its low price.
• The company has reached a state of mature earnings.
• The company is experiencing some inconsistent earnings.

No PE Ratio:

• This just means that the company has no earnings.  Think about what happens when a company isn’t making any money?  Mathematically we can’t divide by zero.  So in this case we say they don’t have a PE Ratio.

The fundamental lesson: You can never really just look at the number alone and make a black/white conclusion.  Always consider other factors that may attribute as to WHY the value is higher or lower.  All stock metrics should always be used in conjunction with one another to tell the whole story.

Disclaimer: I own shares of T.

Readers: How often do you pay attention to the PE ratio when making decisions about your stock prospects?

Related Posts:

1. Using the Dividend Yield Formula to Evaluate a Stock Prospect
2. Can the Dividend Payout Ratio Help You Pick a Good Stock?
3. Rethinking My Strategy for What Stocks to Buy This Year

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