Price-To-Earning (P/E)

What is P/E?

P/E ratio is a financial valuation metric. By comparing the stock price (market price) with its earnings per share (company’s “actual (by actual, it means the price derived solely based on the earning)” price), the ratio indicates whether the market values the company on a fair level. Generally speaking, when we compare the P/E ratio between similar companies, lower P/E means a company is undervalued, and higher P/E means a company is overvalued.

Calculation

For financial ratios, it is important to understand the calculation, because only by so, investors can fully understand its functions, and can apply it under different scenarios when needed. The P/E ratio is calculated by dividing the stock price by Earnings Per Share (EPS). Specifically, EPS is a measurement of a company’s profitability. Therefore, the calculation of P/E suggests a comparison between the market’s value (stock price) and the company’s value based on its profitability (EPS). By doing so, the P/E ratio can imply some information whether a company is undervalued or overvalued.

• Price-to-Earning = Stock Price ÷ Earning Per Share
• Earning Per Share = (Net Income - Dividend) ÷ Shares Outstanding

How to Apply This?

P/E ratio is a relative valuation approach, meaning it provides information only if investors company the ratio between similar companies or companies in the same industry.

There are several applications of the P/E ratio depending on the scenario. Usually, high-growth industries, such as technology or industrial industries, tend to have a higher P/E ratio than other high-value industries. This is because of the fact that in these companies, their earnings are often low, even negative since they often invest a lot in research and development in the initial stage. Hence, it is surely not critical to compare the P/E ratio of companies from totally different industries.

The P/E ratio is often compared between companies that are in the same industry or share some similarities. The P/E ratio can also be compared with a company's historical P/E ratio to understand how the valuation of that company changes throughout time.

Alternatives of the P/E Ratio

As mentioned above, sometimes, the P/E ratio could be especially high, and sometimes, the ratio could be negative. When facing these cases, alternatives to the P/E ratio could be helpful. The first alternative is the forward P/E, which considers the predicted earnings. If a company just started up and has not made a profit yet, but is believed to make one in the future, future P/E could be a suitable alternative.

Another useful alternative for the P/E ratio is the PEG ratio. It stands for Price/Earnings - to Growth ratio. PEG considers the factor of growth of earning. Therefore, sometimes even if a company is having low earnings, as long as the growth rate for the earnings is high, it will still be considered undervalued according to the PEG.