P/E Ratio - Price/Earnings
The PE Ratio (Price/Earnings Ratio) is an equity valuation metric. It is also known as Earnings Multiple and Price Multiple. It is referred to as the "multiple", because it indicates how much investors are willing to pay per dollar of earnings.
P/E Ratio - Price/Earnings Ratio
The Price/Earnings Ratio (PE Ratio) is an equity valuation metric. It is also known as Earnings Multiple and Price Multiple. The ratio is referred to as the "multiple", because it indicates how much investors are willing to pay per dollar of earnings.
Price/Earnings Ratio Formula
The PE Ratio is calculated by dividing the market value per share by the Earnings Per Share (EPS).
There are multiple versions of the ratio depending on the type of earnings and time period used. Three examples are:
- PE Ratio TTM: uses the net income for the trailing twelve month (TTM) period divided into the average number of common shares over the same period
- PE Ratio TTM from continuing operations: uses the company's operating earnings, excluding accounting changes, earnings from discontinued operations and extraordinary items
- Projected PE Ratio: uses the mean estimated current year or next year net earnings, as provided by analysts from various financial publications
Price/Earnings Ratio Interpretation
The PE Ratio is the most popular method of evaluating prospective investments. Both price and earnings are readily available and represent the (inverted) earnings yield. Note that for companies experiencing losses (negative earnings), the multiple will be reported as N/A, whereas the earnings yield will be a negative number.
The PE Ratio provides an indication of how much the market is willing to pay for a company’s earnings. A higher figure indicates that the market has high hopes for the future of the company and investors are willing to buy shares at a premium price. However, a high earnings multiple may not signify a good investment due to share overpricing.
A lower earnings multiple indicates the market does not have as much confidence in the company. This may not always be a negative investment factor because the share price may be undervalued.
It should be noted that "higher" and "lower" PE Ratio are subject to interpretation. The mean value varies from industry to industry and for different time periods.
The most prominent problem with the PE Ratio is that the denominator includes non-cash items such as depreciation or amortization. The earnings can easily be manipulated by playing with these items. This is why a large number of investors now use Price/Cash Flow Ratio which removes non cash items and considers cash items only.
Good quantitative factors exhibit relationships with stock returns that not only have a fundamental and/or theoretical basis for stock returns but are also stable and persistent over time. The P/E Ratio is such a factor, having been correlated with past stock returns for decades and also expected to be correlated with future returns.
In the world of quantitative analysis, the investment horizon is referred to as "rebalance period", indicating the period of time a stock is held before refreshing the portfolio holdings. While some quantitative factors achieve good results with weekly, monthly or quarterly rebalance, the P/E Ratio typically requires an investment horizon of at least 1 year to exhibit "good" results.
The Quantitative Analyst assesses individual stock factors by:
- separating the stocks into quintiles (or deciles) based on the value of the factor
- calculating the performance of each quintile based on rebalance period and total back-test period
- analyzing the spread of performance between Quintile 1 to Quintile 5
Ideally the performance spread should be "monotonic", meaning that Quintile 1 outperforms Quintile 2, Quintile 2 outperforms Quintile 3, and so forth.
Using the above process, the stocks from the Russell1000 Index were evaluated over the 10 year backtest period 2005-2014 with a 1 year rebalance period.
From the above column chart, it can be seen that the quintiles exhibit monotonic behavior. However, the spread of performance between Quintile 1 and Quintile 5 does not compare to that of the Price/Cash Flow Ratio, making the latter a better metric.
In Quantitative Analysis, single factor back-tests are not executed to generate real-life performance figures or to outdo a benchmark. At this stage the Technical Analyst is simply trying to identify whether the stock factor contains useful predictive value. There are many other considerations involved in the construction of a portfolio that will change the performance numbers.