Price to Earnings ratio is jargon used by equity research analysts, experts in valuation, stock brokers, fund managers, as well as present and prospective investors.
Let us take a look at the nuts and bolts of this valuation metric and its variants.
What does it measure?
P/E multiple measures the number of times the share of a company is priced in the stock market compared with its earnings. It is the market price per share/earnings per share.
For example, the P/E ratio of State Bank of India is 20.7 times, if we consider the trailing to market earnings per share of Rs 153.5. This is known as Trailing P/E Ratio.
Note that the higher the P/E, the longer it would take for investors to earn their money back.
A high PE, therefore, indicates that investors expect the company`s earning power to go up. Low P/E shares, on the other hand, are generally low-growth or mature companies. They often have long records of earnings stability and regular dividends, and are usually relatively safe investments.
Alternatively, we can compute the Historical P/E Ratio for SBI by dividing its current market price by its last year [2010] EPS; the 2010 EPS for the company was Rs 144.37. The historical price to earnings ratio, therefore, would be about 22. While these two are the most commonly used P/E ratios - as both are based on actual earnings and hence the most accurate - it is forward PE that holds more relevance to investors when evaluating a company.
Forward P/E multiple
Forward P/E multiple reveals the number of times the price of the stock is traded in the market compared with its estimated next year EPS.
For instance, if we expect a 15% increase in the earnings of SBI, then the forward PE would be 19 times (i.e. 3181/166). When you compare the stock`s trailing P/E with its forward P/E, you may find the stock more attractive on a forward PE basis, as it is lower than the trailing PE due to higher earnings growth expectations.
There are also times when we need to predict the P/E for future, when it is over and above one year. Without getting into the technicalities of earnings projection, let`s suppose that the EPS of SBI is expected to be Rs 300 after five years.
Then the future P/E Ratio for the stock would be about 11 times. This is much lower than both historical and trailing price to earnings ratio.
Note that the P/E multiple comes down drastically due to the steep increase in the forecast EPS; the opposite holds true for a steep decline in the forecast e EPS number.
All the variants of P/E are based on the same numerator (i.e. market price per share) but use different denominators (i.e. earnings per share- historical, trailing, forward and future). You can also consider taking the 6 -12 months median market price of the share for computing the price to earnings multiples. Doing this may help you avoid the problem of outliers to a greater extent.
Determinants of P/E Ratio:
The P/E multiple of a company is determined by many factors but the key determinants are (a) Expected Growth Rate (b) Current and Future Risk and (c) Current and Future investment needs.
Companies with a higher expected growth rate in business normally trade at a higher P/E multiple, as the earnings are expected to be more attractive in future. When the estimated EPS is higher, the forward P/E is lower compared with the current P/E. So, when the market gets this information, the share price goes up as then investors would be willing to pay a higher price for the stock. Therefore, companies with higher growth rates trade at higher P/E multiples.
However, companies perceived as risky usually trade at lower multiples, as the market expects fluctuations in their operating results.
For instance, companies with higher operating leverage (higher proportion of fixed costs to total costs) and higher financial leverage (higher debt/equity ratio) are perceived to be riskier, by the market.
P/E ratio is also affected by the reinvestment needs/requirements of a company. For example, a company with higher reinvestment needs is perceived as riskier, as it would then require the company to borrow more funds. This may lead to a higher financial leverage or earnings dilution for existing shareholders depending on the method adopted to raise funds.
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