If the Price to Earnings Multiple (P/E) were to be judged by usage, it wins easily compared to any other valuation metric, that are available. It is easy to compute, can be applied across companies and across sectors, with a few exceptions. What is this ratio, how is it computed, and how to use it are questions to which you will find answers here !.
What is a P/E multiple?
The P/E multiple is the premium that the market is willing to pay on the earnings per share of a company, based on its future growth. The ratio is most often used to conclude whether a stock is undervalued or overvalued. The P/E is calculated by dividing the current market price of a company’s stock by the last reported full-year earnings per share (EPS). In effect, the ratio uses the company’s earnings as a guide to value it.
A variant of the P/E – called the Forward P/E – has also been developed wherein the current market price of the stock is divided by the expected future EPS. The attempt to study P/E ratios in this manner reflects the effort to factor in the expected growth of a company.
How is a P/E multiple used?
P/E multiples reflect collective investor perception regarding a company’s future. This perception is a function of various factors, like industry growth prospects, company’s position in industry, its growth plans, quantum change expected in sales or profit growth, quality of management, and other macroeconomic factors like interest rates and inflation.
Is a stock trading at a P/E of 30 more expensive than a stock trading at a P/E of 40?
Such a wide variation in P/E multiples can be owing to a few reasons. If the companies are in the same industry, it could be that the company with a high P/E may be one with superior size and financials, with better prospects or even better management. The market expects this stock to outperform its peers. If they are from different industries, it could also be due to different growth prospects.
Besides different expectations regarding future earnings growth, some of the difference in P/E can also be attributed to the disclosures made by the management to their shareholders. Hence, qualitative factors like transparency, quality of management also impact a stock’s P/E.
Stock prices, in isolation do not give any indication whether the stock is undervalued or overvalued. They have to be viewed along with the company’s future prospects to arrive at any conclusion. Generally, higher the expected growth in a company’s earnings, higher is the P/E multiple that it attracts in the market. The time period used for P/E calculations depends on the investment horizon of the investor and would be different for each investor. However, P/E multiples cannot be applied to loss making companies since they do not have any earnings, as such.