Historical background of the P/E (Price/Earnings) Ratio
The P/E ratio has historically been quoted and used by most industry investors as a quick and simple indicator of a stock’s value.
The P/E ratio is also widely quoted in the media and is frequently used in business valuations of an organization’s stock. This P/E ratio is then compared to industry benchmark price/earnings ratios.
What Precisely Does the Price/Earnings Ratio Mean?
Simplistically the P/E ratio is calculated for a quoted company as:
- “Share Price / Earnings Per Share (EPS)”.
Industry investors also quote this ratio as:
- “Share value of a company = EPS x ( P/E ratio of a comparative company)”.
What does the Price/Earnings Ratio Mean to Industry and the Investor?
Industry and investors will look at the relative size of the Price/Earnings ratio. This is because a high P/E ratio implies that investors are content to pay a high multiple of today’s earnings for the company.
Why Would Investors Pay a High Earnings Multiple for a Company? (Creating a High P/E)
There are two key drivers of higher Price/Earnings ratios, namely:
- Future growth prospects of company (& industry)
The future earnings of the company are expected to be high due to the future growth potential. - Perceived risk of company (or industry)
Shares that are considered lower risk usually offer a higher Price/Earnings ratio. This is due to the security they provide.
Why Does Industry View the P/E Ratio as Important? (Industry Comparisons, Historical Analysis etc.)
Investors find it useful to compare the Price to Earnings ratio of a company compared to the P/E ratio of the industry. This helps provide a relative gauge of how the company is perceived. P/E comparisons are also carried out between one industry and another industry. The P/E ratio is only an indicator and simply raises more questions, however it is still an important financial ratio. Historical Price/Earnings ratio analysis also provides useful data, since this historical analysis when compared with the industry analysis can help provide some indications for the future P/E ratio.
What Are the Key Problems With Price to Earnings Ratio Analysis of a Company, or an Industry?
The 3 Possible Key Problems with the Price to Earnings Ratio are:
- Investors & industry place too much emphasis on the P/E ratio: it is not the “silver bullet” that it is often portrayed as.
- Investors & industry often do not carry out deep fact based comparative analysis (the market often gets the calculation incorrect).
- Investors & industry often find it difficult to get comparative P/Es or industry benchmark P/E ratios (especially true for unquoted stock).
What are the Possible Secondary Problems with P/E Ratio Analysis of a Company, or an Industry?
Possible secondary problems with the P/E ratio include the following:
- P/E ratios use historical data. Historic data is not always a sound basis for future earnings.
- Historic accounting policies can vary significantly between countries (for example there are significant differences between UK GAAP and US GAAP).
- The P/E can vary due to short-term influences (eg recent poor historic results).