The Price-to-Earnings (P/E) Ratio

Lesson note: This recording uses historical Apple figures from fiscal 2019 and a stock price shown at the time. For the stated inputs, $270.325 divided by $11.97 is approximately 22.6 times earnings. Use price and EPS on the same split-adjusted basis when calculating a current ratio.

Basic Definition

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 earnings 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.

Simple Example

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 is 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?

A share represents a proportional ownership interest in the company. Investors value the cash flows they expect shareholders to receive over time, discounted for timing and risk. The company may retain earnings rather than distribute them, and future earnings are uncertain.

(We cover this in a 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 using basic, not diluted, earnings per share here.

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. 

Using the figures stated in this example, divide $270.325 by $11.97 of basic earnings per share. The result is about 22.6 times earnings.

A 22.6-times P/E means the share price is about $22.60 for each $1 of annual earnings per share used in the calculation. This example uses the historical fiscal year shown in the recording.

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, as of this spring 2020 recording, 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 said 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. 

EPS Estimates

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. 

EPS Adjustments

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: Investors may pay a higher multiple of current earnings when they expect future earnings to increase. Those expectations can change or fail to materialize.

• Stability: Investors may be willing to pay more for earnings they expect to be relatively stable. That expectation does not make the earnings guaranteed or a company 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 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, such as during the 2020 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. 

The Inverse of P/E: Earnings Yield

The inverse of the P/E ratio is the earnings yield. At 20 times earnings, it is 1/20, or 5%. Earnings yield is not a promised investment return or a dividend yield.

A higher P/E corresponds to a lower earnings yield, and a lower P/E corresponds to a higher earnings yield. Growth expectations, risk, accounting differences, and the sustainability of earnings all affect how investors interpret those figures.

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? 

Benefits

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-to-earnings ratio tells you how much you're paying for those earnings. 

Shortfalls

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 that there's no way to account for growth. When I tell you Apple is trading at 23 times last year's earnings or 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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