Price Earnings Ratio – Is it Good For Measuring Stock Values?

The price earnings ratio, or pe ratio, is one of the most common financial ratios but not necessarily the best understood. It is calculated by dividing the current price by the earnings per share.

If the trailing earnings per share for the last 12 months is used in the calculation, then the ratio is referred to as the trailing pe ratio. If the earnings estimates for the next four quarters are used, the ratio is referred to the forward pe ratio.

The p e ratio is quite often incorrectly used as a measure of stock value. The intrinsic value of a stock is calculated using the company’s economic fundamentals, not its price. The price is what one investor is prepared to pay to another at any point in time. As Warren Buffett has remarked – price is what you pay, value is what you get.

But the price earnings ratio is commonly used as a quick and easy relative measure of stock value by comparing the current p/e of the stock to that of its market sector and to that of the market as a whole. Online brokers’ sites should provide this information. This comparison provides an indication as to whether the stock is undervalued or overvalued.

The ratio commonly varies from a low value of four to a high value of 30, but some companies may have P/E’s values that lie outside of this range. A p/e of 15 means that the stock price is 15 times annual earnings of the company. That is, 15 years of earnings would be needed to cover the price paid. This can be expressed by the equation…

Price of the share = p/e ratio x earnings per share

One way to use the price earnings ratio is to consider a stock a potential buy when its p/e, or price to earnings multiple, is close to the lower end of its average annual range. It is more likely at that point that the price is close to, or below, its intrinsic value.

However, as the p/e is not an absolute measure of value, it is guess work unless you can more accurately estimate the stock fair value using the fundamentals of the company.

A number of factors may affect the magnitude of the p/e ratio. It may be that the p/e is depressed because the whole market has suffered a downturn as the result of a global recession, or concern of one occurring. In this case, the depressed p/e may have nothing to do with the individual performance of the company, and the company may represent excellent buying.

On the other hand, the depressed value may be associated with some factor that the market has decided will affect the future earnings of the company in question. Reading the company annual and interim reports and market announcements would be a useful exercise.

All stocks exhibit a range of p/e values during any one year as the price of the stock fluctuates. A lot of the variation in the P/E ratio of shares is due to market ‘noise’ and has little to do with the value of a stock.

Buying a share when its p/e is at the low end of its average annual variation will ensure that, as the p/e rises (assuming it will) and as the earnings of the company grows (assuming it will), the share price will increase over time as per the formula above.

This is why investors should look to buy shares that have good earnings per share growth and have their current price earnings ratio at the low end of their average annual range. As well, high return on equity and low debt should also be a prerequisite for any stock purchase.