In this lesson, we're gonna discuss the price-to-earnings ratio, or P/E ratio, and why financial analysts and investors use it.
Let’s start with the basic definition.
The price-to-earnings ratio tells you how many times earnings investors are paying for the stock of a company. It’s the stock price divided by the earning per share. For example, if a company makes $1 in earnings, and the company’s stock price trades at $15 per share, the P/E ratio is 15x.
Let's use a simple example. A company earns $5 EPS or earnings per share, and its stock price trades at $100. What's the P/E ratio?
It's the price divided by earnings per share: $100 divided by five is 20x. The p/e ratio 20 (usually we denote that as 20x). This means that for every one dollar of earnings, investors are willing to pay 20 times that in value.
Why Pay a Multiple of Earnings?
Why would you pay more than let's say 1x a company's earnings? Why are you willing to pay more for a company's earnings?
As a shareholder, you are entitled to all the future earnings that a company generates, not just the next year or the next five years. You own a piece of the company forever and those earnings are worth a lot when you discount them back to the present value.
[we have a whole separate lesson on discounted cash flow modeling]
The P/E ratio gives you a quick snapshot as to how much you're paying relative to a company's earnings and it makes it easy to compare one company’s valuation to another.
Apple’s P/E Ratio: A Real-World Example
Let's use a real-world example of Apple. Let's start with Apple's latest fiscal year earnings. I'm going to bring in Google here and I'm gonna go to my tool to quickly find financial data bamsec.com, and type in the ticker AAPL. From there, I’m going to the latest annual report, fiscal year 2019.
From the homepage, I could click item eight which takes me to the key financial statements, including the income statement. In the income statement, I see that the company generated in the twelve months ended September 28th, 2019, they generated $11.97 in earnings. [we're not gonna discuss the difference between basic and diluted earnings now we're just gonna use the basic earnings per share the company generated $11.97 of earnings in the fiscal year ended September 28 2019]
Next, I need to find Apple’s latest closing price. I'm going to go back to Google and I'm just typing in “AAPL stock price” and I'm going to see that Apple closed today at $270.325.
So what was the current p/e ratio based on the most recent EPS? Well, I'll do equals my price divided by my earnings, that's 22.8. Let's put one decimal and again I would think about that as 22.8 with an X at the end.
22.8x earnings means that for every one dollar of earnings you're paying almost 23x earnings for Apple stock price. That's using Apple's most recent historical year.
Forward P/E Ratio
You can also calculate what's known as a forward P/E ratio, meaning a P/E ratio based on future earnings. Let's do that now. What is the consensus EPS forecast for Apple’s upcoming fiscal year? To calculate that I'm going to type into Google “AAPL earnings estimates Nasdaq." I'm going to use the link that takes us to the nasdaq.com page for Apple.
Nasdaq will aggregate the analysts' estimates. These analysts publish earnings estimates for companies. If I go down to yearly earnings forecasts, I can see that in the next year ending September 2020 the consensus EPS forecast is $12.40.
There's a high forecast of $14.37 and a low forecast of $10.88.
There are 11 estimates and over the last four weeks eight analysts have decreased their estimates and that's because we're in the midst of the coronavirus pandemic and analysts are rushing to lower not only Apple's estimates but the rest of company's estimates as well.
The consensus EPS forecast is $12.40 based on 11 analysts so $12.40 I'm gonna put in here based on how many analysts we set 11 and we said that eight analysts have revised it downward in the last four weeks.
What is the forward P/E ratio? Well, I take the stock price that we used above and I divided by next year's earnings, the September 2020 number, and I get a forward P/E ratio of 22x (compared to almost 23x last year's earnings).
Now, why is that? Well, on a forward basis I'm paying less because earnings are growing so the P/E ratio is only 22x instead of 23x. Now one thing to think about here is who are these analysts making these estimates. Are these estimates reliable? That's the big question and in reality, no one can accurately predict earnings on a consistent basis.
When you're using consensus EPS the estimates are okay for a company like Apple, which many analysts cover. 11 is a good number and they update those estimates frequently but for other companies that aren't as followed you might only have a couple of estimates and they might not be updated as frequently so it's not always something you can trust.
Additionally, the further you go out typically the less reliable those estimates are and fewer analysts will post estimates. You can see if you go to September 2022 only two analysts are publishing estimates for that period so you can't just say well analysts are projecting this amount of earnings so that's a reliable number.
What you really have to do is look at a bunch of analysts, look at a bunch of their reports, and maybe even come up with your own estimates, but it is a full-time job.
That's what investment banks, hedge funds, buy-side, and sell-side analysts are doing all the time. They are updating their models to come up with the best estimates. With the p/e ratio as with many other things in finance, it's only as good as the inputs that you use.
Now one thing I didn't discuss before in the past year EPS is when you take that EPS number from last year it might not be a clean EPS number. There might be some one-time adjustments that happen. Maybe the company had a one-time restructuring charge and maybe you need to adjust for it.
On the flip side maybe it had a one-time revenue deal or one-time income that you shouldn't include.
The idea here is that we get sort of a stabilized earning number so we can get a clean snapshot of what the company is trading at relative to its earnings today.
Key Drivers of P/E
Let's discuss the drivers of p/e ratios. Why would a company have a high p/e ratio? The two main reasons a company would have a high p/e ratio, meaning that investors are willing to pay more for every dollar of earnings:
Growth: If you expect the company's earnings to grow you might be willing to pay or you'll probably be willing to pay more for today's earnings or even next year's earnings in hopes that those earnings grow and in the future, you're essentially paying so.
Stability: The more stable the company's earnings are the more you'd be willing to pay because you're getting more guaranteed earnings. Investors like stability, they like guarantees, they don't like volatility so you would typically see higher multiples on companies that are more stable, more dominant, more recession-proof.
Conversely, when would you see a low price to earnings ratio you would see a lower price to earnings ratio. If a company's earnings are not growing or even declining and if that company's earnings are very choppy year in and year out and are subject to large declines in times of recession.
Typically you would see cyclical industries like travel - airlines and hotels - sometimes trade at a lower price to earnings ratios because during recessions those earnings might decline and year in and year out they could be more volatile. Another reason to see a lower price to earnings ratio is if a company has a lot of debt which adds risk and volatility.
Especially in bad times like this during the coronavirus pandemic, a high debt load could increase the chances that a company goes into bankruptcy or financial distress.
Investors are not willing to take on extra risk and pay a high multiple unless they're compensated for that risk. When you pay a high multiple okay you're paying more for every dollar of earnings.
P/E as a Return
Let's flip the price to earnings ratio. Let's say you pay a 20x price-to-earnings ratio that means for every $1 you're paying $20. For every $1, you're paying $20. If I flip that, it’s a 5% return which would be a low return for the stock market. The stock market now trades at around 16 or 17 times.
You might be willing to take a lower return. If I flip it one over 20 is 5%. I'd be willing to take a lower return because I have more stability or more growth, but if I had higher leverage, choppier earnings, or lower growth I would need a higher return to compensate for that. Maybe the price to earnings ratio will be 10 times or 1 over if I flip 10 to one flip it 1 over 10 which would be 10%, a higher return than the 5%.
Benefits & Shortfalls of P/E
Let's discuss the benefits and shortfalls of price to earnings ratios. First, why do financial analysts and investors use p/e ratios?
Well, they use p/e ratios because it's very easy to calculate and easy to compare across companies. You might say well this company trades at 18x and that company trades at 15x so the company that trades at 15x looks cheaper because you think it's gonna grow just as fast. I think that could be a buy.
It’s very easy to compare and calculate so it's convenient for investors. Another reason they use it is it gives you a rough estimate of what you're paying or how expensive a company is pretty easy and it does give you some sort of estimate. Basically at the end of the day earnings are extremely important, if not the most important thing, that a company generates so calculating the price or earnings ratio tells you how much you're paying for those earnings.
However, there are many shortfalls in this. As we discuss in our DCF modeling video. The value of a company is the value of all its future cash flows, the p/e ratio is only a point in time you could only use one earnings number.
Let's say next year or last year maybe you could even do an average of three years. Sure, but when you value a company you have to look at all the future earnings and by using a single earnings number in the denominator you're not capturing the full value of the company.
Another thing when looking at p/e ratios is this is there's no way to account for growth. When I tell you Apple is trading at 23 times last year's earnings are 22 times forward earnings that doesn't tell you anything about the company's growth. Again it's just a point in time.
It also doesn't tell you anything about a company's leverage or risk or stability of cash flows so for many reasons the price to earnings ratio has its shortfalls. It doesn't really tell you enough but it does tell you something just to get you going.
More Free Investing & Finance Resources
If you really want to value a company properly you have to look at a wide range of metrics ratios and financial modeling, I definitely recommend looking into other videos and tutorials that we have on topics like dividend yields, DCF valuation, and financial accounting to get a complete picture on a company's valuation and prospects.
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