Price–earnings ratio

Robert Shiller's plot of the S&P Composite Real Price-Earnings Ratio and Interest Rates (1871–2012), from Irrational Exuberance, 2d ed. In the preface to this edition, Shiller warns that "[t]he stock market has not come down to historical levels: the price-earnings ratio as I define it in this book is still, at this writing [2005], in the mid-20s, far higher than the historical average. ... People still place too much confidence in the markets and have too strong a belief that paying attention to the gyrations in their investments will someday make them rich, and so they do not make conservative preparations for possible bad outcomes."

In stock trading, the P/E ratio (price-to-earnings ratio) of a share (also called its "P/E", or simply "multiple") is the market price of that share divided by the annual Earnings per Share (EPS).

The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies: a higher P/E ratio means that investors are paying more for each unit of current net income, so the stock is more "expensive" than one with a lower P/E ratio. The P/E ratio can be regarded as being expressed in years: the price is in currency per share, while earnings are in currency per share per year, so the P/E ratio shows the number of years of earnings which would be required to pay back the purchase price, ignoring inflation, earnings growth and the time value of money.

Definition

The P/E ratio is defined as:

${\mbox{P/E ratio}}={\frac {\mbox{Market Price per Share}}{\mbox{Annual Earnings per Share}}}$

The price per share in the numerator is the market price of a single share of the stock. The earnings per share in the denominator may vary depending on the type of P/E:

• "Trailing P/E" or "P/E ttm": Here earnings per share is the net income of the company for the most recent 12 month period, divided by the weighted average number of common shares in issue during the period. This is the most common meaning of "P/E" if no other qualifier is specified. Monthly earnings data for individual companies are not available, and in any case usually fluctuate seasonally, so the previous four quarterly earnings reports are used and earnings per share are updated quarterly. Note, each company chooses its own financial year so the timing of updates will vary from one to another.
• "Trailing P/E from continued operations": Instead of net income, this uses operating earnings, which exclude earnings from discontinued operations, extraordinary items (e.g. one-off windfalls and write-downs), and accounting changes. Longer-term P/E data, such as Shiller's, use net earnings.
• "Forward P/E", "P/Ef", or "estimated P/E": Instead of net income, this uses estimated net earnings over next 12 months. Estimates are typically derived as the mean of those published by a select group of analysts (selection criteria are rarely cited). In times of rapid economic dislocation, such estimates become less relevant as the situation changes (e.g. new economic data is published, and/or the basis of forecasts becomes obsolete) more quickly than analysts adjust their forecasts.

As an example, if stock A is trading at $24 and the earnings per share for the most recent 12 month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of the stock is paying $8 for every dollar of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio (usually shown as "not applicable" or "N/A"); sometimes, however, a negative P/E ratio may be shown.

Some people mistakenly use the formula market capitalization / net income to calculate the P/E ratio. This formula will often give the same answer as market price / earnings per share, but if new capital has been issued it will give the wrong answer, as market capitalization = market price × current number of shares whereas earnings per share= net income / weighted average number of shares.

Variations on the standard trailing and forward P/E ratios are common. Generally, alternative P/E measures substitute different measures of earnings, such as rolling averages over longer periods of time (to attempt to "smooth" volatile or cyclical earnings, for example), or "corrected" earnings figures that exclude certain extraordinary events or one-off gains or losses. The definitions may not be standardized. For companies which are loss-making or whose earnings are expected to change dramatically, a "primary" P/E can be used instead, based on the earnings projections made for the next years to which a discount calculation is applied.

Interpretation

By comparing price and earnings per share for a company, one can analyze the market's stock valuation of a company and its shares relative to the income the company is actually generating. Stocks with higher (or more certain) forecast earnings growth will usually have a higher P/E, and those expected to have lower (or riskier) earnings growth will usually have a lower P/E. Investors can use the P/E ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal (especially the earnings growth rate), it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, companies, and time periods may be misleading. P/E ratio in general is useful for comparing valuation of peer companies in similar sector or group.

Various interpretations of a particular P/E ratio are possible, and the historical table below is just indicative and cannot be a guide, as current P/E ratios should be compared to current real interest rates (see Fed model):

N/A	A company with no earnings has an undefined P/E ratio. By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, even though a negative P/E ratio can be mathematically determined.
0–10	Either the stock is undervalued or the company's earnings are thought to be in decline. Alternatively, current earnings may be substantially above historic trends or the company may have profited from selling assets.
10–17	For many companies a P/E ratio in this range may be considered fair value.
17–25	Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in future.
25+	A company whose shares have a very high P/E may have high expected future growth in earnings, or this year's earnings may be considered to be exceptionally low, or the stock may be the subject of a speculative bubble.

It is usually not enough to look at the P/E ratio of one company and determine its status. Usually, an analyst will look at a company's P/E ratio compared to the industry the company is in, the sector the company is in, as well as the overall market (for example the S&P 500 if it is listed in a US exchange). Sites such as Reuters offer these comparisons in one table. Often, comparisons will also be made between quarterly and annual data. Only after a comparison with the industry, sector, and market can an analyst determine whether a P/E ratio is high or low with the above mentioned distinctions (i.e., undervaluation, over valuation, fair valuation, etc.).

Using discounted cash flow analysis, the impact of earnings growth and inflation can be evaluated. Using constant historical earnings growth rate of 3.8 and post-war S&P 500 returns of 11% (including 4% inflation) as the discount rate, the fair P/E is obtained as 14.42. A stock growing at 10% for next five years would have a fair P/E of 18.65.

Effect of leverage

Example—effect of leverage on the PE ratio

P/E ratios are highly dependent on capital structure. Leverage (i.e. debt taken on by the company) affects both earnings and share price in a variety of ways, including the leveraging of earnings growth rates, tax effects and impacts on the risk of bankruptcy, and can sometimes dramatically affect the company's results. For example, for two companies with identical operations and taxation regime, and trading at typical P/E ratios, the company with a moderate amount of debt will commonly have a lower P/E than the one with no debt, despite having a slightly higher risk profile, slightly more volatile earnings and (if earnings are increasing) a slightly higher earnings growth rate.

At higher levels of leverage (where the risk of bankruptcy forces up debt costs) or if profits decline substantially (driving up the P/E ratio) the indebted firm will have a higher P/E ratio than an unleveraged firm.

To try to eliminate these leverage effects and better compare the values of the underlying operating assets, it is often preferable to use multiples based on the enterprise value of a company, such as EV/EBITDA, EV/EBIT or EV/NOPAT.

The market P/E

To calculate the P/E ratio of a market index such as the S&P 500, it is not accurate to take the unweighted average of the P/Es of all the constituents: since it is a capitalization-weighted index, it is better to calculate a weighted average: each stock's underlying market caps (share price multiplied by number of shares in issue) are summed to give the total market capitalization for the whole index. The underlying net earnings (earnings per share multiplied by number of shares in issue) of each company are similarly totalled, giving the total earnings for the whole market index. The final stage is to divide the total market capitalization by the total earnings to give the total market P/E ratio. One way to find a market index P/E ratio is to look up the P/E ratio of an exchange-traded fund that tracks the index. For example SPY tracks the S&P 500 Index, while VTI tracks the Wilshire 5000 index.

An often used variation is to exclude companies with negative earnings from the summation - especially when looking at sub-indices with a relatively few stocks, where companies with negative earnings will seriously distort the figures.

In Stocks for the Long Run, Jeremy Siegel argues that the earnings yield is a good indicator of the market performance on the long run. The average P/E for the past 130 years has been 12.1 (i.e. an earnings yield of 8.3%).

Historic values in the USA

Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert Shiller (Figure 10.1, source). The horizontal axis shows the real price-earnings ratio of the S&P Composite Stock Price Index as computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Data from different twenty year periods is color-coded as shown in the key. See also ten-year returns. Shiller stated in 2005 that this plot "confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."

Since 1900, the average P/E ratio for the S&P 500 index has ranged from 4.78 in Dec 1920 to 44.20 in Dec 1999,. However, except for some brief periods, during 1920-1990 the market P/E ratio was mostly between 10 and 20.

The average P/E of the market varies in relation with, among other factors, expected growth of earnings, expected stability of earnings, expected inflation, and yields of competing investments. For example, when US treasury bonds yield high returns, investors pay less for a given earnings per share and P/E's fall.

The average U.S. equity P/E ratio from 1900 to 2005 is 14 (or 16, depending on whether the geometric mean or the arithmetic mean, respectively, is used to average).

Jeremy Siegel has suggested that the average P/E ratio of about 15 (or earnings yield of about 6.6%) arises due to the long term returns for stocks of about 6.8%. In Stocks for the Long Run, (2002 edition) he had argued that with favorable developments like the lower capital gains tax rates and transaction costs, P/E ratio in "low twenties" is sustainable, despite being higher than the historic average.

Set out below are the recent year end values of the S&P 500 index and the associated P/E as reported. For a list of recent contractions (recessions) and expansions see US Business Cycle Expansions and Contractions.

Date	Index	P/E	EPS growth %	Comment
2009-06-30	919.32	122.41	--
2009-03-31	797.87	116.31	--
2008-12-31	903.25	60.70	--
2007-12-31	1468.36	22.19	1.4
2006-12-31	1418.30	17.40	14.7
2005-12-31	1248.29	17.85	13.0
2004-12-31	1211.92	20.70	23.8
2003-12-31	1111.92	22.81	18.8
2002-12-31	879.82	31.89	18.5
2001-12-31	1148.08	46.50	-30.8	2001 contraction resulting in P/E Peak
2000-12-31	1320.28	26.41	8.6	Dot-com bubble burst: March 10, 2000
1999-12-31	1469.25	30.50	16.7
1998-12-31	1229.23	32.60	0.6
1997-12-31	970.43	24.43	8.3
1996-12-31	740.74	19.13	7.3
1995-12-31	615.93	18.14	18.7
1994-12-31	459.27	15.01	18.0	Low P/E due to high recent earnings growth.
1993-12-31	466.45	21.31	28.9
1992-12-31	435.71	22.82	8.1
1991-12-31	417.09	26.12	-14.8
1990-12-31	330.22	15.47	-6.9	July 1990-March 1991 contraction.
1989-12-31	353.40	15.45	.
1988-12-31	277.72	11.69	.	Bottom (Black Monday was Oct 19, 1987)

Note that at the height of the Dot-com bubble P/E had risen to 32. The collapse in earnings caused P/E to rise to 46.50 in 2001. It has declined to a more sustainable region of 17. Its decline in recent years has been due to higher earnings growth.

Inputs

Accuracy and context

In practice, decisions must be made as to how to exactly specify the inputs used in the calculations.

• Does the current market price accurately value the organization?
• How is income to be calculated and for what periods? How do we calculate total capitalization?
• Can these values be trusted?
• What are the revenue and earnings growth prospects over the time frame one is investing in?
• Were there special one-time charges which artificially lowered (or artificially raised) the earnings used in the calculation, and did those charges cause a drop in stock price or were they ignored?
• Were these charges truly one-time, or is the company trying to manipulate us into thinking so?
• What kind of P/E ratios is the market giving to similar companies, and also the P/E ratio of the entire market?
• Are P/E ratios an accurate measure?

The P/E ratio in business culture

The P/E ratio of a company is a significant focus for management in many companies and industries. Managers have strong incentives to increase stock prices, firstly as part of their fiduciary responsibilities to their companies and shareholders, but also because their performance based remuneration is usually paid in the form of company stock or options on their company's stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders). The stock price can increase in one of two ways: either through improved earnings or through an improved multiple that the market assigns to those earnings. In turn, the primary drivers for multiples such as the P/E ratio is through higher and more sustained earnings growth rates.

Consequently, managers have strong incentives to make decisions that are both earnings accretive, even in the short term, and/or which improve long term growth rates. This can influence business decisions in several ways:

• If a company is looking to acquire companies with a company with a higher P/E ratio than its own it will usually prefer paying in cash or debt rather than in stock. Although in theory the method of payment makes no difference to value, doing it this way will offset or avoid earnings dilution (see accretion/dilution analysis).
• Conversely, companies with higher PE ratios than their targets will be more tempted to use their stock as a means of payment for acquisitions.
• Companies with high P/E ratios but volatile earnings may be tempted to find ways to smooth earnings and diversify risk - this is the theory behind building conglomerates
• Conversely, companies with low P/E ratios may be tempted to acquire small high growth businesses in an effort to "rebrand" their portfolio of activities and burnish their image as growth stocks and thus obtain a higher PE rating.
• Companies will try to smooth earnings, for example by "slush fund accounting" (hiding excess earnings in good years to cover for losses in lean years). Such measures are designed to create the image that the company always slowly but steadily increases profits, with the goal to increase the P/E ratio.
• Companies with low P/E ratios will usually be more open to leveraging their balance sheet. As seen above, this mechanically lowers the PE ratio, which means the company looks cheaper than it did before leverage, and also improves earnings growth rates. Both of these factors will help drive up the share price.

Other related measures

P/E10

P/E10 uses average earnings for the past 10 years. There is a view that the average earnings for a 20 year period remains largely constant, thus using P/E10 will reduce the noise in the data.

PEG ratio

PEG ratio is obtained by dividing the P/E ratio by the annual earnings growth rate. It is considered a form of normalization because higher growth rates should cause higher P/E ratios.

PVGO

Present Value of Growth Opportunities (PVGO) is another alternative method for stock valuation. Present value of growth opportunities is calculated by finding the difference between price of equity with constant growth and price of equity with no growth.

PVGO = P(Growth) - P(No growth) = [D1/(r-g)] - E/r

where

D1 = Dividend for next period

r = Cost of Capital or the capitalization rate of the company

E = Earning on equity

g = The growth rate of the company.

Since the Price/Earnings (P/E) Multiple is 'Price per share / Earnings per share' it can be written as

P0 / E1 = 1/r [ 1+ (PVGO/(E1/r))].

Thus, as PVGO rises, the P/E ratio rises.

Earnings yield

Main article: Earnings yield

The reciprocal of the P/E ratio is known as the E/P or earnings yield.

The earnings yield is quoted as a percentage, and is useful in comparing a stock, sector, or the market's valuation relative to bonds. The earnings yield is also the cost to a publicly traded company of raising expansion capital through the issuance of stock.

The earnings yield is an estimate of the expected return from holding the stock if we accept certain restrictive assumptions (a discussion of these assumptions can be found here).

Price/dividend ratio

Publicly traded companies often make periodic quarterly or yearly cash payments to their owners, the shareholders, in direct proportion to the number of shares held. According to US law, such payments can only be made out of current earnings or out of reserves (earnings retained from previous years). The company decides on the total payment and this is divided by the number of shares. The resulting dividend is an amount of cash per share.

Just as P/E is the ratio of price to earnings, the Price/Dividend ratio is the ratio of price to dividend.

Dividend yield

Main article: Dividend yield

The dividend yield is the dividend paid in the last accounting year divided by the current share price: it is the reciprocal of the Price/Dividend ratio.

If a stock paid out $5 per share in cash dividends to its shareholders last year, and its price is currently $50, then it has a dividend yield of 10%.

Historically, stocks with very high P/E ratios pay little if any dividends. Theoretically speaking, if the dividend exceeds the earnings, the company may be seen as returning capital to its investors, a situation that can not persist indefinitely.

Relationship between measures

Several of these measures are related to each other: given price, earnings, and dividend, there are 6 possible ratios, which come in reciprocal pairs:

• P/E ratio and earnings yield are reciprocals;
• P/D ratio and dividend yield are reciprocals;
• Dividend payout ratio (DPR) = Dividend/EPS, while the reciprocal is dividend cover (DC) = EPS/Dividend.

They are related by the following equations:

• P/E = P/D * DPR and P/D = P/E * DC;
• taking reciprocals, earnings yield = dividend yield * DC and dividend yield = earnings yield * DPR.

See also

• Dividend yield
• Fundamental analysis
• List of finance topics
• Stock market
• Stock market bubble
• Stock market crash
• Stock valuation
• Value investing
• Valuation using multiples

External links

• How to Use the P/E