If you’ve ever had a discussion about company valuations or if you’ve ever dabbled in stock investing, the term P/E ratio – or price to earnings ratio – comes up quite often. Essentially, a company’s P/E ratio tells us how much investors are willing to pay for every dollar the company makes. In short, the P/E ratio represents a company’s share price to its earnings per share (EPS). This computation can be described in the formula below:

Here’s an example of how this formula would work:

Company A is trading at $40 per share, and its earnings over the last 12 months have been $2 per share. Based on these amounts, the P/E ratio for Company A’s stock would be calculated as 40/2, or 20 – investors in Company A’s stock are willing to pay $20 for every dollar Company A earns.

Data used to derive P/E ratios need not be restricted to a company’s trailing P/E (based on EPS over the past 12 months). Depending on the purpose of your calculations, you may wish to use a company’s average annual EPS over a period of 10 years (also known as P/E 10 ratio), projected EPS based on analyst estimates (also known as forward P/E), or even a combination of historical data and projected estimates.

**What does a P/E ratio tell us?**

Using the correct data, the simple P/E ratio can reveal a lot of information about a company’s financial prospects.

Even though data used in the calculations for P/E ratios are based on historical figures, the P/E ratio actually provides insight into the future. The numerator – Market Value per Share – is the price that investors are willing to pay for a company’s shares, which is based on investors’ predictions and estimates. Based on these considerations, a P/E ratio can actually shed light on the company’s expected growth of earnings.

A relatively high P/E ratio (the market average tends to be 20 to 25) would generally mean that the market is expecting robust growth from the company. In order to maintain the ratio, the company would have to perform well to live up to the market’s expectations or risk a drop in the multiple. On the other hand, a relatively low P/E ratio would mean that the company’s growth is expected to slow down, or is simply out of favour.

**Flipping the ratio – earnings yield**

Another piece of financial information that can be derived from the P/E ratio is a company’s earnings yield. This is done by switching the numerator with the denominator of the P/E ratio formula.

Earnings yield represents the percentage of returns made by the company for every dollar invested in its stock. This figure is used by investors as a measure of return on their investment. Generally, earning yields are used in comparative analyses. One such comparison would be with dividend yields through the following formula which determines the company’s Payout Ratio:

The Pay-out Ratio allows you to determine how sustainable the company’s dividend payments are. Higher ratios tend to be less sustainable, which may be some cause for concern to investors if the company is in a volatile sector like resources and energy supply.

Another example would be to add a company’s growth rates to the earnings yield and compare it to the P/E ratio. According to the ‘Father of Value Investing’, Benjamin Graham, as long as a company’s growth + earnings yield is higher than their P/E Ratio, you would be unlikely to experience severe losses on a well-diversified portfolio.

**What else should be considered?**

There are several other factors that should be considered when it comes to the reliability and relevance of a company’s P/E ratio. Here are some points that should be noted when calculating P/E ratios:

1. Company growth rates – When calculating a trailing P/E ratio, it is important to ensure that historical growth rates justify a company’s P/E ratio. Sometimes, companies may have been experiencing low growth rates but enjoy high P/E ratios. This would mean that the company may be overvalued, and calculations may have to be based on forward P/E instead of trailing P/E.

2. Industry – When comparing P/E ratios, it would be good to consider industry averages. This means that we cannot compare P/E ratios of food & beverage companies with technology companies since the growth rates and scalability differ greatly. When using P/E ratios to determine the value of a company’s shares, it would be more accurate to make comparisons with companies in the same industry.

3. Accounting – A P/E ratio’s reliability really depends on the accuracy and transparency of the company’s accounting. Skewed and false financial reporting may lead to inaccurate EPS figures which will eventually jeopardise the validity of a company’s P/E ratio. Essentially, a P/E ratio is only as good as the company’s integrity when it comes to bookkeeping. Some examples of how a company may distort their EPS figures include changing depreciation policies, adding or subtracting non-recurring gains and expenses, and even tweaking their pension obligations through inflated discount rates.

The P/E ratio is a great tool to aid you in your assessment of a company’s stock, but while simple, there are many factors to consider. In order to optimize its effectiveness, it would be best to conduct a holistic analysis through other calculations and ratios.