Price to Earnings ratio is a relative valuation metric used to determine whether the company under consideration is undervalued or overvalued when compared with its peers and industry average. As the term relative valuation suggests, this metric on its own has no use. For it to provide the requisite valuation information about a company, it has to be compared with the same ratio of other companies operating in the same industry or sector as well as with the industry average. We shall try to understand this metric as well as its uses and importance with an example as we proceed forward.
The P/E Ratio or Price/Earnings Ratio is the ratio of market price of a share of a company divided by the earnings per share of the company:
P/E Ratio = Market Price or Traded Price Per Share / Earnings Per Share
If we are to multiply both the numerator and denominator by total number of shares outstanding, we get:
P/E Ratio = Market Capitalization of the Company / Total Annual Profit of the Company
At its essence, P/E measures how much you are willing to pay for each unit of profit per share. For e.g. a share price of € 100 and an Earnings per Share of € 10 has a P/E of 10. This means that you are willing to pay € 10 per € 1 of earnings or profit per share. When comparing P/E of one company with its peers and industry, you determine whether you are paying more for that profit or less. You want to be paying less so that when the market recognizes the stock’s fair value, you get higher returns.
Let us look at P/E of Walmart Inc. which is one of the largest chain of supermarkets in the world alongside its peers Costco Wholesale and Target Corp as well the industry average. Since these are US based companies, the currency in our discussion shall be US Dollar ($).
As one can see, P/E of Target is half of industry average as well as its peers. It is undervalued when compared to its peers because you need to pay only $18.27 per dollar of profit as compared to the industry average of $36.24 per dollar of profit. Costco on the other hand has a P/E higher than its peers as well as industry average. It is considered overvalued as you are paying $37.56 per dollar of profit as compared to $36.24 in the industry. Walmart can be considered fairly valued as its P/E is in line with the industry average.
P/E is affected either by a change in share price or a change in underlying earnings. If share price goes up while earnings remain the same, P/E will rise and vice versa if share price goes down. Alternatively if earnings go up while share price remains the same, P/E will go down. The following table will be able to highlight this relationship easily.
Now let us look at the performance of these stocks in the last one year:
As you can see, Target has generated a massive 92% return. It has experienced a sharp increase in share price which was followed by an increase in earnings as well. Walmart and Costco on the other hand have not done quite as well. There is a lot of potential for further increase in the price of Target Corp as even if its earnings remain the same, for its P/E to reach fair value, its share price will have to nearly double from its current point.
P/E ratio in its absolute is no indicator of undervaluation or overvaluation. A company with a P/E of 10 can be overvalued and one with a P/E of 50 can be undervalued. It all depends on its valuation relative to its competitors and within the industry. A good P/E ratio will be one which will be much less than its competitors and the industry average, but not too less. A P/E ratio upto half or at the most 60% lesser than industry average is a good enough ratio.
P/E ratio less than that is something that requires further examination. For e.g. a company with a P/E ratio of 10 when the industry average is 50 cannot be taken as undervalued on face value. There must be some problems inherent in its financials or operations for it to trade at a P/E as low as that.
Also P/E ratio as a standalone valuation metric is not enough. It has its advantages and disadvantages. A couple of drawbacks of P/E ratio are as follows:
It tends to overvalue high growth companies:
Young companies experiencing a high growth rate will tend to be overvalued by traditional P/E ratio. For e.g. a company with a share price of € 100 and an EPS of € 5 will have a P/E of 20 which when compared to an industry average P/E of 15 will be overvalued. However the company is experiencing a high growth rate of up to 100% annual growth in profits. By next year, it will have an EPS of € 10 reducing its P/E to 10 and considering the share price to be the same presenting the company as undervalued.
It tends to ignore cyclicality of businesses:
P/E ratios of cyclical businesses do not reflect the cyclical nature of certain businesses like commodities. A metal company will have a low P/E at the top of the metal pricing cycle which might come across as undervalued but is actually overvalued as the downward segment of the cycle will reduce earnings thus sharply increasing the P/E. Thus P/E becomes an unreliable metric when evaluating cyclical stocks Other minor drawbacks include backward looking measure, no integration of negative earnings etc.
One can get our premium membership for as low as € 7.9 per month. In our premium dashboard, one can visit sector analysis to get color coded analysis of various sectors with green signifying undervaluation and red signifying overvaluation.
Once a particular sector has been highlighted, one can look at market leaders in that segment and then drill down to identify companies with lower P/E ratios.
P/E ratio is a quick to calculate and easy to understand valuation metric that can help sift through companies and shortlist undervalued companies. However it is not a standalone metric to decide valuation. One must look at other metrics like Price to Book value and Price to sales as well alongside other metrics. We have over 12 such key financial ratio calculators on our website, all available for free. Calculate the key ratios and build a consensus through them to determine whether a company is truly undervalued or overvalued.
Alternatively, join our premium membership and we will do all of this work for you, providing you various fair values right on your very own premium dashboard.
In my experience, P/E is a pretty nifty tool to shorten a wide list immediately. By going through the sector list, I can look at the undervalued sectors and then simply filter out those that have a P/E higher than average. Once the undervalued company list is ready, I then use other key ratios to build a consensus (For e.g. 7 out of 10 key ratios indicate undervaluation which is a pretty good sign) and drill down on various fundamental aspects of the businesses to make an informed investment decision.
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