Price/Earnings per Share - a Definition, and the Advatages and Disadvantages of P/E

The Formula

When the level of the price of a share is assessed probably the most widely used ratio is the “price to earnings per share” ratio, abbreviated as P/E. Tom Copeland defines P/E as follows, “[P/E approach] assumes the company will be worth some multiple of its future earnings in the continuing period.” (Copeland et. al. 2000, p.284). What this definition means is that the P/E ratio measures the future prospect of a company or industry average taking into account the present conditions and results of these companies and industries. For instance, we examine Company X. According to the Copeland definition, its P/E ratio measure will include the experiences investors had with the current management in the past, the current condition in the terms of its finances, and the basics of other departmental areas, the prospects of the company, and the present and future economical and industry prospects. A benchmarking analysis process of the closest competitors is also conducted by the most careful investors.

After this brief introduction to what the P/E ratio is all about, let me move onto the algebraic area of the P/E ratio analysis.

The formula of the ratio is the following:

P/E=Share Price/Earnings per share

For more information on Earnings per Share please go here.

Returning to Company X, the current share price of Company X is, say, USD 50.00, the company has 10,000,000,000 shares, and had earnings, that is, net profits, of, say, USD 10 billion. Using the above described formula, the Price/Earnings per share of the Company X is:

50/(10,000,000,000/1,000,000,000)=50/10=5

Thus the P/E of Company X is 5. (Although P/E depends on many varying factors, usually industry and sector averages depend on many varying factors, P/E industry averages tend to fall between 10 and 20, with a number of exceptional economic sectors and industries which have P/Es much lower or higher than this “average of industries' average”).

Meaning of the P/E Ratio

As it has been mentioned before, the P/E ratio is, in a large part, formulated by the current optimism or pessimism of the investors, regarding the particular corporate share, or industry average. The reason why this is so, is that in the numerator (the top of the fraction) the price of the share is a key factor and has a direct influence on the result of the ratio. As it is a common sense, the share prices do not change in a solely rational manner. Interestingly enough, the average P/Es traditionally moved somewhere between 10 and 25. ( see historical Standard & Poors P/Es on the left). However, the new internet, also referred to in the media as dotcoms, and software companies, and generally speaking the whole of the IT industry, has a much higher P/E; somewhere around 100. For instance, Yahoo! shares are “some 187-times current profits” (The Economist, 2004, p. 53)

What, for instance a P/E of 15, in practice means? It means that an investor is willing to pay 15 times as much for each stock of the company than net profit they actually generate. The 15-times EPS is the worth of the future prospects of the particular organisation.

Obviously if a company has a P/E that is less than the industry average, than the investors think that many of the competitors of the firm will outperform the company. This means, that on the mid-term (1-5 years) the investors expect the company to probably lose some of its market share; this company is not competitive enough (at least that is the image the particular company has). If the P/E of the company is similar to the industry P/E average, it can mean two things: either the company will keep its market share, or the particular company is the only one in the industry, that it has a monopoly (or oligopoly) of its market. If the P/E is greater than the industry P/E average, than the company will increase its influence on the industry, and probably has some comparative advantage to its competitors operating in the same industry, or market.

Advantages of Using P/E

The biggest advantage of the P/E ratio is that it is easy to use and fathom. Even those who are not educated in finance can understand it, and although it is only a very basic tool and method of evaluating the worth of the shares of a company, it can be used to make quick decisions.

The P/E is a much more indicative means for the real value of the share than the price alone. To better see this, I will show this through an example. A stock with a price of USD100 and a P/E of 10 is much more “cheaper”, so to speak, than a share with a price of USD10 and a P/E of 100. (given that the two shares are from the same industry). This means that P/E is an excellent benchmarking tool both relative to the industry average, and also the the competitors of the specific company. Another way of of benchmarking, the P/E determines to actual expectations of the company. If it is expected to continue to perform well, the share price of the company tend to be higher, thus raising the P/E of the company.

The company's stocks' current P/E can be compared to the past performance of the company. For example, if the EPS of the company has a steady growth (meaning that each share produce a growing amount of profit), yet the P/E of the company tends to be constant or similar, than that means that the growht of the price of the share does not match the growth of the profitability of those shares, thus the company becomes undervalued, and it will qualify as a buy recommendation from stock market analysts.

Disadvantages of Using P/E

Although the P/E ratio has some very distinct advantages, there are also some problems that should be taken heed of.

The first problem is that P/E is largely due to the subjective in nature , and that “we have no idea what price earnings ratio we can sell at (Financial Times 2005, p.8). This can partially be accredited to the volatile nature of stock prices. The volatile nature of stocks can probably be best described by the result of a survey conducted by Kevin P. Coyne and Jonathan W. Witter, which said, this also applicable to large company stocks in the Standard & Poor's 500, or S&P500, index, that the 40-100 most active investors of a particular company account for more than 50% of all changes of stock prices. (Harvard Business Review, 2002, p.71) When the general business and economic environment has an optimistic sentiment, than investors tend to over-price shares, thus raising P/E, even to a level, that, financially speaking, the company records do not justify. This might cause a, so called, bubble, when prices and P/Es are so high that they can at any time burst, or fall sharply, that is, collapse. This was the case with the IT, most notably internet, securities during the early and mid 1990s. There are also times when the economy and the business world are viewed worse than it actually is, for example in economic recessions, and than securities, and shares in particular, are undervalued in terms of their P/Es. There are also regions that are undervalued in terms of P/E when compared with the actual financial statements of the best performing companies in the region. Central and Eastern Europe is such an under-P/E-d region.

If an examined company reports earnings lower than expected by market consesus, than that results in a sudden change in the EPS of the company, since the earnings per shares will also decrease. This in turn causes the P/E to suddenly increase, and thus the price of the the share (at least based on P/E valuation) becomes to high, resulting in an overvaluation of the stock.

If the company generally has a negative image, its stock price tend to reflect that. This might be so even if the actual financial figures and condition of the company does not justify the lower (also referred to as price of the stock having a discount) this financial ratio is also to low. This is especially important if compared to a direct competitor in the same industry that has a very good image, and thus be overvalued. In this case it is quite difficult to determine the correct price of either of those stocks (at least base on the P/E ratio only).

The next disadvantage is inflation. At times of high inflation, the currency of the specific country where the share observation takes place. The problem with this is that if we exchange the earnings of the company to a foreign currency, say from USD to EUR, it can devaluate the earnings of the company, which in turn, given the formula, increases P/E.

The interpretation of the P/E concerning a company is also problematic. Some investors might consider a specific P/E ratio too high, whereas others might consider the same ratio to be too low, even if it is compared with the industry P/E average. This difference in the perceptions rises from the very essence of the ratio; as it was stated earlier in this article, the P/E ratio is solely a matter of Nthe current price.

Conclusion to P/E

The Price/Earnings per share ratio is a very simple method of valuing shares, however, it can only be useful if it is used to compare the company stocks with other company P/Es of the same industry and with the industry average, and with its historical P/E.

  • Theoretically, a stock's P/E tells us how much more investors are willing to pay for each dollar, or any currency, a share earns.

  • The P/E ratio is the current stock price of a company divided by its earnings per share (EPS).

There are some important issues that have to be considered when using the ratio:

  • It is the reflection of the market's optimism concerning a firm's growth prospects.

  • It is a much better indicator of a stock's value than the market price alone.

  • In general, it is difficult to say whether a particular P/E is high or low.

  • P/E ratios are generally lower during times of high inflation.

  • There are many explanations as to why a company has a low P/E.

  • No buy or sell decision should be based on the multiple alone!

Historical DJIA P/E ratios (1935-2006)

Source: http://www.multpl.com
Source: http://www.multpl.com

Statistics to the above chart:

Mean: 16.37
Median: 15.76
Min: 4.78 (Dec 1920)
Max: 44.20 (Dec 1999)

P/Es are based on average inflation-adjusted earnings from the previous 10 years (P/E10)

S&P Reported P/E (1936-2008)

Based on trailing 12-month earnings

QUARTER 12 MO P/E
06/30/2008 24,92
03/31/2008 21,90
2007.12.31 22,19
09/30/2007 19,42
06/30/2007 17,70
03/31/2007 17,21
2006.12.31 17,40
09/30/2006 17,00
06/30/2006 17,05
03/31/2006 17,82
2005.12.30 17,85
09/30/2005 18,46
06/30/2005 18,80
03/31/2005 19,57
2004.12.31 20,70
09/30/2004 19,29
06/30/2004 20,32
03/31/2004 21,66
12/31/2003 22,81
09/30/2003 25,82
06/30/2003 28,21
03/31/2003 27,97
2002.12.31 31,89
09/30/2002 27,14
06/30/2002 37,02
03/31/2002 46,45
12/31/2001 46,50
09/30/2001 36,77
06/30/2001 33,28
03/31/2001 25,54
12/31/2000 26,41
09/30/2000 26,75
06/30/2000 28,02
03/31/2000 29,41
12/31/1999 30,50
09/30/1999 29,18
06/30/1999 33,46
03/31/1999 33,52
12/31/1998 32,60
09/30/1998 26,70
06/30/1998 29,10
03/31/1998 27,86
12/31/1997 24,43
09/30/1997 23,31
06/30/1997 21,83
03/31/1997 18,82
12/31/1996 19,13
09/30/1996 19,09
06/30/1996 19,21
03/31/1996 18,96
12/31/1995 18,14
09/30/1995 16,61
06/30/1995 15,82
03/31/1995 15,38
12/31/1994 15,01
09/30/1994 16,93
06/30/1994 17,63
03/31/1994 19,63
12/31/1993 21,31
09/30/1993 22,49
06/30/1993 23,31
03/31/1993 22,77
12/31/1992 22,82
09/30/1992 23,16
06/30/1992 23,94
03/31/1992 24,93
12/31/1991 26,12
09/30/1991 21,77
06/30/1991 19,12
03/31/1991 17,92
12/31/1990 15,47
09/30/1990 14,08
06/30/1990 16,84
03/31/1990 15,69
12/31/1989 15,45
09/30/1989 14,74
06/30/1989 12,61
03/31/1989 11,81
12/31/1988 11,69
09/30/1988 11,96
06/30/1988 12,62
03/31/1988 13,93
12/31/1987 14,12
09/30/1987 20,29
06/30/1987 21,08
03/31/1987 19,32
12/31/1986 16,72
09/30/1986 15,58
06/30/1986 17,05
03/31/1986 16,45
12/31/1985 14,46
09/30/1985 11,96
06/30/1985 12,29
03/31/1985 11,02
12/31/1984 10,05
09/30/1984 10,03
06/30/1984 9,46
03/31/1984 10,43
12/31/1983 11,76
09/30/1983 12,49
06/30/1983 13,32
03/31/1983 12,32
12/31/1982 11,13
09/30/1982 8,88
06/30/1982 7,74
03/31/1982 7,56
12/31/1981 7,98
09/30/1981 7,61
06/30/1981 8,74
03/31/1981 9,33
12/31/1980 9,16
09/30/1980 8,57
06/30/1980 7,65
03/31/1980 6,68
12/31/1979 7,26
09/30/1979 7,47
06/30/1979 7,36
03/31/1979 7,64
12/31/1978 7,79
09/30/1978 8,86
06/30/1978 8,51
03/31/1978 8,17
12/31/1977 8,73
09/30/1977 9,01
06/30/1977 9,64
03/31/1977 9,76
12/31/1976 10,84
09/30/1976 11,02
06/30/1976 11,27
03/31/1976 11,87
12/31/1975 11,33
09/30/1975 10,81
06/30/1975 11,96
03/31/1975 9,87
12/31/1974 7,71
09/30/1974 6,97
06/30/1974 9,84
03/31/1974 11,24
12/31/1973 11,95
09/30/1973 14,10
06/30/1973 14,42
03/31/1973 16,40
12/31/1972 18,39
09/30/1972 18,00
06/30/1972 17,95
03/31/1972 18,45
12/31/1971 17,91
09/30/1971 18,11
06/30/1971 18,55
03/31/1971 19,22
12/31/1970 17,96
09/30/1970 15,73
06/30/1970 13,17
03/31/1970 15,92
12/31/1969 15,93
09/30/1969 15,81
06/30/1969 16,73
03/31/1969 17,44
12/31/1968 18,03
09/30/1968 18,14
06/30/1968 17,88
03/31/1968 16,58
12/31/1967 18,10
09/30/1967 18,25
06/30/1967 17,01
03/31/1967 16,55
12/31/1966 14,47
09/30/1966 13,89
06/30/1966 15,52
03/31/1966 16,71
12/31/1965 17,81
09/30/1965 18,06
06/30/1965 17,38
03/31/1965 18,41
12/31/1964 18,63
09/30/1964 18,83
06/30/1964 18,87
03/31/1964 18,89
12/31/1963 18,66
09/30/1963 18,11
06/30/1963 18,07
03/31/1963 17,94
12/31/1962 17,19
09/30/1962 15,94
06/30/1962 15,78
03/31/1962 20,64
12/31/1961 22,43
09/30/1961 21,88
06/30/1961 21,33
03/31/1961 21,06
12/31/1960 17,77
09/30/1960 16,37
06/30/1960 17,46
03/31/1960 16,32
12/31/1959 17,67
09/30/1959 16,58
06/30/1959 17,20
03/31/1959 17,83
12/31/1958 19,10
09/30/1958 17,38
06/30/1958 15,44
03/31/1958 13,41
12/31/1957 11,87
09/30/1957 12,22
06/30/1957 13,85
03/31/1957 12,97
12/31/1956 13,69
09/30/1956 13,11
06/30/1956 13,05
03/31/1956 13,14
12/31/1955 12,56
09/30/1955 12,69
06/30/1955 12,74
03/31/1955 12,36
12/31/1954 12,99
09/30/1954 12,29
06/30/1954 11,15
03/31/1954 10,56
12/31/1953 9,88
09/30/1953 9,16
06/30/1953 9,62
03/31/1953 10,41
12/31/1952 11,07
09/30/1952 10,40
06/30/1952 10,67
03/31/1952 10,15
12/31/1951 9,74
09/30/1951 9,27
06/30/1951 7,71
03/31/1951 7,56
12/31/1950 7,19
09/30/1950 7,15
06/30/1950 6,96
03/31/1950 7,30
12/31/1949 7,22
09/30/1949 6,52
06/30/1949 5,90
03/31/1949 6,33
12/31/1948 6,64
09/30/1948 7,48
06/30/1948 9,00
03/31/1948 8,82
12/31/1947 9,50
09/30/1947 9,75
06/30/1947 10,56
03/31/1947 11,94
12/31/1946 14,43
09/30/1946 16,81
06/30/1946 21,94
03/31/1946 20,09
12/31/1945 18,08
09/30/1945 16,32
06/30/1945 14,96
03/31/1945 14,21
12/31/1944 14,28
09/30/1944 14,20
06/30/1944 14,11
03/31/1944 12,92
12/31/1943 12,41
09/30/1943 11,19
06/30/1943 11,23
03/31/1943 10,82
1942.12.31 9,49
09/30/1942 9,41
06/30/1942 8,47
03/31/1942 7,70
1231/1941 7,49
09/30/1941 8,57
06/30/1941 9,04
03/31/1941 9,40
12/31/1940 10,08
09/30/1940 9,87
06/30/1940 9,60
03/31/1940 12,37
12/31/1939 13,88
09/30/1939 16,07
06/30/1939 14,29
03/31/1939 15,46
12/31/1938 20,64
09/30/1938 19,74
06/30/1938 15,01
03/31/1938 8,76
12/31/1937 9,34
09/30/1937 11,28
06/30/1937 13,16
03/31/1937 16,14
12/31/1936 16,84

source: www2.standardandpoors.com/spf/xls/index/sp500pe_ratio.xls

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