The first thing investors consider when discussing a stock is whether the stock is cheap or expensive: the Price-to-Earnings (P/E) Ratio. It is among the most popular tools of financial analysis to value companies and compare opportunities of investment.
What Is the Price-to-Earnings(P/E) Ratio?
Price-to-Earnings(P/E) ratio indicates the amount that investors are prepared to spend nowadays on every dollar that a firm is earning. It actually shows how much investors are willing to pay today for a company’s earnings.
It’s calculated as:
- Market Price per Share (P): The current trading price of one share.
- Earnings per Share (EPS): The company’s net profit divided by the total number of outstanding shares.
In simple words:
If a stock has a P/E of 20, it means investors are willing to pay $20 for every $1 the company earns.
Why Is the P/E Ratio Important?
- It helps in measuring the valuation of a business: It indicates whether a stock is over-priced, under-priced, or fairly priced.
- Easy Comparison: Investors make comparisons between the P/E ratios of companies operating in the same sector.
- Growth Expectation: When P/E is high, it is a sign that investors anticipate high growth in the future.
- Profitability Insight: It demonstrates the efficiency of a company in generating profit through its operations.
Types of Price-to-Earnings(P/E) Ratios
P/E ratios are mainly of three kinds, including Trailing P/E, Forward P/E, and Justified P/E.
Trailing P/E Ratio (Based on Past Earnings)
Definition:
The trailing P/E involves the historical earnings of the company (historical EPS) of the preceding 12 months.
Example:
If a company’s share price is $100 and its last year’s EPS was $5,
That means investors are paying 20 times last year’s earnings.
Interpretation:
- A high trailing P/E may indicate optimism or overvaluation.
- A low trailing P/E may indicate undervaluation or declining performance.
Forward P/E Ratio (Based on Expected Earnings)
The forward P/E relies on the future earnings (anticipated EPS in the coming year).
Example:
If a company’s share price is $100 and next year’s expected EPS is $6,
This shows the stock looks cheaper based on future earnings growth.
Interpretation: Forward P/E assists investors in knowing the expectations of the market concerning the performance of the company in the future.
Justified P/E Ratio (Based on Fundamentals)
The Justified P/E Ratio indicates the value of the P/E ratio, which should be according to the financial fundamentals of a company its growth rate (g), its payout ratio, and its required rate of return (r).
Justified P/E Ratio is based on the Gordon Growth Model, which is a correlation between stock value and growth, and expected dividends.
Formula for Justified P/E Ratio:
There are two versions:
- Justified Forward P/E:
- Justified Trailing P/E:
Where:
- r = Required rate of return (investor’s expected return)
- g = Dividend or earnings growth rate
- Payout ratio = Dividend ÷ Earnings
Step-by-Step: How to Calculate the Justified P/E Ratio
Let’s walk through an example:
Example:
For FPL Group Inc. (FPL), an analyst gives the following forecasts:
- Dividend payout ratio = 50% (0.5)
- Growth rate, g = 5%
- Required rate of return, r = 9%
Step 1: Identify the formula
Use the Justified Forward P/E formula:
Step 2: Plug in the values
Step 3: Solve
Step 4: Find the Justified Trailing P/E
Final Answer:
- Justified Forward P/E = 12.5
- Justified Trailing P/E = 13.13
Interpreting the Justified P/E Ratio
- A higher justified P/E suggests strong growth prospects and low risk.
- A lower justified P/E suggests slower growth or higher risk.
- Comparing the actual P/E to the justified P/E helps investors decide if a stock is overvalued or undervalued.
Quick Comparison Table
| Type of P/E | Basis | Formula | Purpose |
|---|---|---|---|
| Trailing P/E | Past EPS | ( P_0 / EPS_0 ) | Shows historical valuation |
| Forward P/E | Future EPS | ( P_0 / EPS_1 ) | Shows expected valuation |
| Justified P/E | Fundamentals | (Payout) / (r – g) | Shows fair valuation based on growth and return |
Final Thoughts
Price-to-Earnings(P/E) ratio is a foundation of stock valuation. With knowledge on Trailing, Forward, and Justified P/E, investors will make more informed decisions not necessarily by the market prices, but by the actual financial fundamentals.
A company that has a stable payout policy, good growth rate, and an affordable cost of equity will tend to have a higher justified P/E, which will indicate long-term investor confidence.