The content of this article
The earnings multiple, P/E ratio, is a popular way of valuing a stock in fundamental analysis. This is because it is easy to calculate and many online banks and websites report this financial ratio.
Here you learn how to calculate the P/E ratio and how you as an investor can use it.
How to calculate the P/E ratio
The actual formula for calculating the P/E ratio is as follows:
P/E ratio = Stock price / Earnings per share (EPS)
If a stock is priced at 88 USD and the earnings per share is 10 USD, you get 88/10 = 8.8.
The P/E ratio is 8.8.
The S&P 500 has had an average P/E ratio of about 16 over the past 100 years.
Negative P/E ratio
If the P/E ratio is negative, it means that the company makes a loss and this makes the P/E ratio quite uninteresting to look at when analyzing and valuing. It is above all in companies that make a profit that the P/E ratio is relevant.
The value of a company
Firstly, all players on the stock exchange dispute what the “real value” of the stock exchange’s companies really is. To calculate a value by reading reports, fixed assets, etc. where everyone together, in a chorus, can exclaim “this is the company’s worth!” is impossible.
If it had been that simple, people would have made significantly fewer mistakes on the stock market. That is why it is called company valuation and not company facts. But there are still a number of financial ratios / valuation multiples that help us understand the company’s current valuation in relation to profit, sales, etc. The P/E ratio is just such a ratio.
Definition & explanation
The P/E ratio is also called the profit multiplier. That’s because it’s exactly what you’re finding out. You will find out how many years it will take before you get your invested money back through the company’s profits. You rarely need to figure it out yourself as most online brokers provide it in their stock data.
We make another calculation as an example to clarify the formula.
Assume that a company’s stock today is at $ 6.50 and that the company made a profit last year of $ 1.04 per share. Then we calculate P/E by taking 6.50 / 1.04 = 6.25.
Therefore, you can now conclude that it will take 6.25 years before you get your investment back. Or?
Of course, if you assume that earnings and the stock price will remain at exactly the same levels. They will not do that. As with all valuation multiples, it only gives a clue about the valuation right now. As soon as the company’s profit or stock price changes, the P/E ratio also changes.
What do you use the P/E ratio for?
P/E ratio is a good ratio to create a first picture of how high or low a stock is valued and to compare the P/E ratio with other equivalent companies.
It is also important that you follow the P/E over a period of five years. Then you see how the ratio has developed over time.
But, do not stare blindly at the P/E ratio alone. It can be misleading and must therefore be combined with other ratios and valuation principles.
Important about the P/E ratio
- Important 1: The companies have the opportunity to adjust the profit both upwards and downwards with accounting technical measures, which can make the P/E ratio misleading.
- Important 2: The P/E ratio does not take into account the company’s indebtedness. It can be especially important to examine the company’s debts to get a clear picture of whether the P/E ratio is misleading or not.
- Important 3: If you use the P/E ratio exclusively to make your assessment, it will be too one-sided. It is necessary to consider more factors and valuation multiples. Use the P/E ratio by comparing it with other equivalent companies’ P/E numbers. Ideally, the companies you are comparing with should be in the same industry. Then you can see how the companies are valued in relation to each other.
- Important 4: The P/E ratio does not take into account the company’s growth. A high P/E ratio can quickly become low if the company grows well. Then a higher P/E is justified.
- Important 5: A low P/E ratio does not have to mean that the stock is cheap. A low number often means that the market thinks that the company will not grow its sales and profits particularly sharply in the future. Therefore, it can often be more interesting for those who want rapid rises in the stock price to invest in companies with high P/E ratios or sometimes even negative P/E. The P/E ratio simply says nothing about where the stock price is going!