Saturday, 14 January 2012

P/E Ratio

What is P/E?
P/E is the price/earnings ratio. In essence, the P/E compares the share price of the company to its earnings per share.

How is P/E calculated?
P/E is calculated using the following formula:
(Market value per share) / (Earnings per share)

What are different types of P/E?
There are three main types of P/E, trailing, rolling, and forward. Trailing P/E is the price/earnings ratio for the past four quarters, or one year. Rolling P/E is the price/earnings ratio for the past two quarters as well as the projected next two quarters. Forward P/E is the price/earnings ratio for the projected next four quarters, or one year. Rolling and Forward P/E are less accurate than trailing P/E because they utilize projected figures.

Why is P/E important?
P/E is important because it helps you look at a company's growth. A higher P/E suggests that the public expects the company to grow more in the future than a company with a lower P/E. For example, high-technology companies like Google can have an astronomical P/E of around 70, whereas very established consumables companies like Wal-Mart usually have a lower P/E of around 20. P/E essentially tells you how many years of earnings it would take for a company to equal its present value. Wal-Mart would need about 20 years, and Google 70. The reason for this disparity is that Google's earnings are expected to grow much more rapidly, and because of this it will eventually take much less than 70. That is why the forward P/E is so important.

Average S&P P/E
As you can see in this P/E chart for 60 years, average P/E can fluctuate widely, but in the past decades it is rapidly increasing and tends to be in between 10 and 25.

Watch out for...
Although P/E is a very good metric to use, there are various ways that it can be manipulated to represent something that the companies want you to see. P/E is based upon the earnings of the company, and the accounting process could come up with numbers that don't accurately reflect the true state of the company. In addition, inflation and deflation can affect the P/E, so it is important to look at P/E over a period of time instead of just one to determine the trends.

No comments: