The PE Ratio: Calculation and Interpretation

Price to Earnings (PE) is ratio often considered to be the most important ratio in the fundamental analysis of stocks. While looking at PE ratio alone may not be sufficient, it is unlikely that a dyed-in-the-wool analyst to will ignore it. Price to earnings ratio links the operational efficiency of a business to the market price of its shares. In this piece we will first see how this simple ratio is calculated and then look at possible ways to interpret it .The price in the PE (or P/E) refers to the market price of the shares of the company for which the ratio is to be calculated. The Earnings “E” in the ratio refers to the annual earnings (read profits) of the company on a per share basis. Suppose a company has issued 100 crore shares, with each share currently trading at Rs52, the
and the company earned a profit of Rs 278 crores in the Financial Year 10(FY10 i.e. April 1st 09 to March 31st 10).The earnings per share (EPS) as you might have guessed are 278/100=Rs 2.78(Since profits are in rupee units and the no of shares do not have units). Since this EPS is calculated on the basis of past (known) profits it is called “trailing” EPS. Another popular version of EPS called the forward EPS which utilizes future earnings for the next four quarter is called the “forward” EPS. Since the future earnings of a business are not known but have to be estimated, it goes without saying that correctness of these earnings estimates is heavily dependent upon the ability of the analyst and different analysts will arrive at their of estimates of earnings.

Now if you own 1000 shares of the company your share of company profits is Rs (278 crores/100 crores)*1000(=Rs 2780), which is quite simply the Earning per share times the No of shares held. The company management may decide to do any of the three things with the Rs 278 crore profits earned.

1) It can give away all the profits to the owners (i.e shareholders) in the form of dividends. In this case since you hold 1000 shares you will get Rs 2780 and an investor who holds 1 lac shares will get EPS* No of shares held i.e. Rs 2.78 lacs.
2) Companies in their growth phase are usually cash hungry and they need a large amount of cash for activities such as setting up a new plant, setting up business in new geographies, setting up R & D facilities so on and so forth. If this is the case with the company at hand, it may not choose to distribute dividends to its owners but reinvest the profits earned to fund to the growth of the business.
3) The third approach a company can use is the mixture of the two approaches above, that is the company may distribute the fraction of its profits and choose to reinvest the rest into the business. Suppose the company above chooses to distribute 115 crores as dividends. Then the dividend per share (DPS) is 115crores/100 crores(=Rs 1.15 ) and the Dividend payout ratio is DPS/EPS or alternatively Total Dividends/Total profits=115/278=0.413

Having seen what the earnings are and what are the ways a company deals with the earnings, let’s come to the P/E ratio. PE ratio is simply the division of the current market price of the company shares with the earnings per share. So in the case of the company above if the shares are trading at a price of Rs 52, the PE ratio of the company would be Rs 52/Rs 2.78 = (18.7). If the company stock price goes to Rs 50 a day later the PE would change to 18. PE ratio can be expressed in multiple forms. Lets look some of the ways an analyst may state the PE ratio of the above company.

X’s share is trading at 52 and it discounts its trailing 4 quarter earnings by 18.7
X’s share is trading at 18.7x (x stands for times) its trailing 4 quarter earnings
X’ share is trading at a PE (FY10 earnings) ratio of 18.7
X’s share is trading at 52 and at an earnings multiple of 18.7 on a trailing basis.
so on and so forth

The higher the PE the more you are paying for every rupee of earnings the company generates. So seen in this sense higher PE stocks are more expensive then lower PE ones.

Consider a hypothetical scenario of 4 companies, A, B, C, D identical in every respect (Industry, Products, Sales, assets, profits, debt, ownership structures, share price etc). Now suppose company A announces the discovery of a raw material source close its factories, which would significantly lower its transportation costs and hence enhance its profitability. Even if the trailing earnings of all the four companies are equal, the next 4 quarter expected profits of company A are higher than that of other companies. The company A which was identical in all respects till a few moments back, now appears to be likely to outdo the other companies in the current year expected profits. In neutral market conditions the markets will re-rate the stock of company A. By rerating we simply mean that the post the arrival of good news the increased demand for the company shares will cause their market price to surge and hence its PE gets automatically rerated to higher value. This adjustment may be slow or may be fast, according to the Efficient Market Hypothesis, markets react quickly to the arrival of new news (good or bad) and rerating process typically takes a few minutes. Experience sometimes shows that markets are not always efficient and it typically takes some time before the change in supply and demand situation, adjusts the stock price so that it starts hovering around a new equilibrium value post a good or a bad news. After the adjustment it can be said that the market is paying a premium (i.e. assigning a higher PE value) for the shares of company A with respect to its peers (B, C, D). So in this example above while the trailing PE of the stock A is higher than that of its peers(same EPS but higher stock price), the forward PE of the stock A may be higher , lower or equal to its peers( higher forward EPS and higher stock price).

PE ratios generally make more sense when comparing two or more companies in the same industry. Consider an industry, in which the PE for the various stocks ranges between 20-22 .An analyst discovers a stock that is trading at a trailing PE of 12, next the analyst through his analysis of the company (using business model, its ability to generate profits, analysis of the Balance Sheet, Profit and Loss statements so on so forth) estimates that the company is likely to grow as fast in profits as the industry on an average. So, the analyst will start believing that the company is undervalued compared to its peers and will buy the stock for himself or will issue a BUY call. In real practice, the analyst will look at some other ratios (ex Price to Sales, Price to book value) before deciding that the stock is undervalued. The buy call is issued In the hope that slowly and gradually the market participants will turn its attention towards the company and the price of it will soar relative to its peers so that it becomes “fully valued” relative to its industry. There can be several reasons as to why the company may be undervalued relative to its industry. Lets look at three of these reasons

1) There was a company specific bad news around 6 months back, so the markets decided to punish the company by lowering its share price, the bad news did not quite have its expected effect on the company’s financial situation but at the same time the share does not recover from the fall
2) Generally bigger players in any industry trade at a higher PE than the smaller ones. The reasons are not too far to seek, a bigger company is deemed to be “higher up on the learning curve” and generally has better access to resources to manage its financial risks and the business risks. Now suppose an analyst finds that a smaller company has recently executed orders which augur well of its ability to compete with some of the big boys in the industry. The company however is trading at a significant discount to the bigger boys in the industry (let us 9x vs 20x) and is growing a bit faster than the industry average. The analyst may expect the discount to reduce going forward so that the company starts trading at PE of say, 12-13 as compared to the industry’s average of 20.
3) The earnings of the company are unlikely to be sustained in the future or the company is subject to greater risks than the industry as a whole.

Here we reproduce a table from Wikipedia (http://en.wikipedia.org/wiki/P/E_ratio) with some alterations. When looking at PE ratio the following points may come in handy

A company with negative earnings (A loss making company)- By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, although a negative P/E ratio can be determined, mathematically. In these case of these companies forward PE may be used if it is positive or the analyst can look towards other ratios (Price to Book Value, Price to Sales) etc.
PE lower than the industry average- Either the stock is undervalued or the company's earnings are thought to be in decline or of unstable nature. So a low PE does not always mean a good BUY
PE more or less equals the industry average-For many companies a P/E ratio in this range may be considered fair value.
PE is above the industry average (let’s say 25 vs. 20) either the stock is overvalued (and should be sold) or the company's earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in future.
PE is way above the industry average (let’s say 40 vs. 20) -A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble. Example of such a stock is RNRL

While this article may serve as an introduction to the highly useful concept of PE ratio,the infomation given above is by no means exhaustive, the ratio is subject to a considerable degree of interpretation. Some extensive reading on the topic and experience in fundamental analysis can help an analyst sharpen his expertise in dealing with ratio.