The Price-Earnings Ratio

The Price-Earnings Ratio (or PE Ratio for short) is one of the most commonly used fundamental measures to compare companies within the same sector. It is effectively a valuation that compares a company's share price to its earnings. The formula is as follows:

PE Ratio = Share Price [divided by] Earnings per Share
 
In real terms this ratio therefore represents how many years it will be until the earnings of a company accounts for the companies share price. Because of this, the PE Ratio can only be used on shares that have positive Earnings per Share (EPS). You cannot use it for a company with negative EPS - the figure you will get will be useless.
 
Calculating PE ratios is therefore relatively easy. Consider this: Company 1 has a share price of 50p and earnings per share (EPS) of 6p. Using these values, divide 50p by 6p. This returns a value of 8.33, which is the PE ratio. On a standalone basis this figure is useless considering there are many other factors that influence the health of a company (e.g. debt) that are not included in the calculation. Furthermore, this should be used comparatively versus other companies. Furthermore, if a company makes a small profit, EPS will likely be low. If this company has a large market cap then the PE ratio will be very high, but this is skewed and therefore not useful. Consequently, you must check the figures beforehand for validity. If those requirements are passed, you are set to go.
 
Real life example:
 
The first step is to locate the share price of the company in question. For this example I will use Adept Telecom (LSE:ADT) which is part of the Fixed Line Telecommunications sector. Adept's share price is currently 142.50p

The next step is to look for the company's last set of financial results. Ideally, these will be the Final, or Full-Year Results. Look for the company's 'Comprehensive Statement of Income' or do a search for Earnings per Share. If multiple figures are shown, use the 'Basic' EPS.


As shown on the last line, for Adept's year-end 2013 results, the Basic EPS stood at 3.17p. Now it is very simple. 142.5 divided by 3.17 retrieves a PE Ratio of 44.95 (or 45). In other words at the current earnings, it would take 45 years for earnings to cover the share price. The next step is to do a quick comparison of other PE ratios within the Fixed Line Telecoms industry. I have tabulated the results below:


From this we can gauge that Adept's PE ratio is quite high, the question then is, what next? The answer is two-fold. Either a company is over-priced, or the company has high growth potential. We already know that the two components that make up the PE ratio are the share price and the Earnings per Share (EPS). If a PE ratio is high, it implies that either the share price will fall in the future to adjust to a more reasonable level, or EPS will rise in the future, also to adjust the PE ratio downwards. How do you know which scenario it is? A quick look at the share price chart is a way to check and looking at a company's last set of results can glean what is to come. This is usually found in the outlook section. On a one-year timescale, the shares in Adept have risen by 168%. Under the outlook section is the following sentence:  "The Board is confident that continued strong cash generation will support a progressive dividend policy."  It would therefore be fair to conclude that the current high PE ratio is due to expectations of increased future EPS.

Other points to note

- Having understood the above, you may wonder whether it is better to invest in a stock with a high PE ratio or a low PE ratio. As I noted earlier, the PE ratio is by no means the complete fundamental analysis package and it should not be relied upon solely in any circumstance. In one light, a high PE ratio may indcate that a company is overvalued and could retrace in terms of share price. In another light, that run could continue and the saying 'Run your shares in profits, and cut the losses' could come into play. My personal preference is to look for low PE shares that the market has overlooked. A share with an unjustifiably low PE could be for a number of reasons, so it is important to check, but in a lot of cases it is because the market has not taken notice of the company in question. A low PE could mean that future expectations for the company are low or moderate. Thus any upside surprise could command a PE ratio re-rating through a higher share price.

- You cannot reliably compare PE ratios between sectors either. Comparing the earnings of a mining company to a utilities company just doesn't work and is no real help. There are disparities between the average PE ratios between sectors as you would expect. Sectors with high growth potential such as Technology companies tend to command a higher average PE ratio to sectors with low growth potential such as Utilities.

- A further point to make is that the EPS figure is subject to accounting techniques. Different companies may use different accounting policies for various reasons, and this may also skew the EPS figure. Therefore the PE ratio is only as useful as the EPS figure from which it's derived. Generally speaking this is not normally an issue as the PE ratio is not a complete measurement

- There are estimates available within the market for a company's expected EPS in the future. This can stretch as far as a few years ahead, but obviously the figures become unreliable. However, using these estimations, Forward PE ratios can be calculated. The whole principle is the same. Assume Company 1's share price is still 60p and its 2014 EPS estimate is 8p. 60p divided by 8p retrieves a PE ratio of 7.5. Therefore Company 1 is trading on 7.5x 2014 earnings. This is generally speaking a low figure (in absolute terms), so you would expect either a share price re-rating upwards, or for Company 1 to miss their 2014 EPS target.

- It is important to remember that the PE ratio you calculate is trailing. It is only representative of a company's results for the last set of EPS announced. Time will have passed, contracts may have been signed or lost and therefore it is no indication of future fundamental performance. A company like Adept may have a high PE ratio now, but after the next set of results it may re-adjust back to below 30. Therefore make sure you check analyst estimates and the company's outlook as well as what was last reported