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In Finance, the PE ratio of a stock (also called its "multiple", or P/E) is calculated as:
Price per Share
---------------
Earnings Per Share
The price per share (numerator) is the market price of a single share of the stock. The Earnings per share (denominator) is the Net Income of the company for the most recent 12 month period, divided by number of shares outstanding.
The PE of a stock describes the price of a share relative to the earnings of the underlying asset. The lower the PE, the less you have to pay for the stock, relative to what you can expect to earn from it. The higher the PE the more over-valued the stock is.
For example, if a stock is trading at $24 and the Earnings per share for the most recent 12 month period is $3, then the PE ratio is 24/3=8. The stock is said to have a PE of 8 (or a multiple of 8).
The main reason to calculate PEs is for investors to compare the value of stocks, one stock with another. If one stock has a PE twice that of another stock, it is probably a less attractive investment. But comparisons between industries, between countries, and between time periods are dangerous. To have faith in a comparison of PE ratios, you should be comparing comparable stocks.
An example
An easy and perhaps intuitive way to understand the concept is with an analogy:
- Let's say, I offer you a privilege to collect a dollar every year from me forever. How much are you willing to pay for that privilege now? Let's say, you are only willing to pay me 50 cents, because you may think that paying for that privilege coming from me could be risky. On the other hand, suppose that the offer came from Bill Gates, how much would you be willing to pay him? Perhaps, your answer would be at least more than 50 cents, let's say, $20. Well, the price earnings ratio or sometimes known as earnings multiple is nothing more than the number of dollars the market is willing to pay for a privilege to be able to earn a dollar forever in perpetuity. Obviously, Bill Gates's PE ratio is 20 and my PE ratio is 0.5.
- But then, think about it this way. The PE ratio also tells you how long it will take before you can recover your investment (ignoring of course the time value of money). Had you invested in Bill Gates, it would have taken you at least 20 years, while investing in me could have taken you less than a year, i.e. only 6 months.
If a stock has a relatively high PE ratio, let's say, 100, what does this tell you? It tells you that you will never be able to recover your investment in your lifetime, at least from dividend earnings. But we see many stocks with such a high PE ratio. Why then are people buying them? It's because people do not expect to keep them for a long time. People are buying those stocks because they think that the price will continue to ride high and even appreciate. Therefore, stocks with extremely high P/E ratio are considered "speculative".
Inputs
In practice, decisions must be made as to exactly how to specify the inputs used in the calculations. Does the current market price accurately value the organization? How is income to be calculated and for what periods? How do we calculate total capitalization? Can these values be trusted?
A distinction has to be made between the fundamental (or intrinsic) PE and the way we actually compute PEs. The fundamental or intrinsic PE examines earnings forecasts. That is what was done in the analogy above. In reality, we actually computed PEs using the latest 12 month corporate earnings. Using past earnings introduces a temporal mismatch, but it is felt that having this mismatch is better than using future earnings, since future earnings estimates are notoriously inaccurate and susceptible to deliberate manipulation.
Related concepts
The PE is calculated primarily for common shares, not for preferred shares. The appropriate calculation for preferreds is the preferred dividend coverage ratio.
A related concept is the PEG ratio. This is the PE ratio adjusted by a growth coefficient. It is sometimes used in high growth industries and new ventures. Its use is controversial.
Another practice, neither mainstream, based on behavioral finance, is to take market behavior parameters, among which the stock image, as factors playing a part in the level and evolution of the PE.
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