What is a Good Price Earnings Ratio?
The Price Earnings Ratio (P/E Ratio) is used by investors to help understand the value of a company. In this article, we go through what the price/earnings ratio is, how to calculate it and how it is used.
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What is the Price Earnings Ratio?
The price-to-earnings ratio (PE ratio) is used to measure the value of a company using its share price relative to its earnings per share figures. It shows how much investors are willing to pay for £1 of a company’s earnings.
The PE ratio helps to understand the expectations of investors and how much they are willing to pay per unit of earnings. It is also known as the earnings multiple. The PE ratio is just one financial ratio that is used to determine whether a stock is undervalued or overvalued.
How is the PE Ratio Calculated?
The formulate to calculate the price to earnings ratio is:
- PE Ratio = Share Price / Earnings per Share
For example, if Company ABC has a share price of £100 and an earnings per share of £5 then the PE ratio is £20 (£100 / £5).
How is the P/E Ratio Used?
The P/E ratio of a stock is used to compare the historical trend of a company’s earnings multiple and to other competitors in the same industry.
A high PE ratio means that investors are expecting a higher level of earnings in the future so are willing to pay more for the stock. This often considered to be growth stocks.
A low PE ratio means that a stock could be trading at a lower price relative to the health of the company. This often considered to be value stocks.
The only way to determine whether a stock has high P/E ratio or low P/E ratio is through a comparison to other companies’ P/E ratios in the same industry.
Trailing PE Ratio vs Forward PE Ratio
There are two types of PE ratios: trailing and forward.
The trailing PE ratio is a historic P/E ratio that is based on the earnings per share over the last 12 months, or financial year.
The forward PE ratio is based on futures estimates, or forecasts of earnings per share for the next financial year that are produced by research analysts.
Let’s say Company ABC has a share price of 200 pence with a trailing earnings per share of 47 pence per share. This means the company’s trailing P/E ratio is 4.2 (200 / 47).
This means that investors are willing to pay a multiple of just over four times current earnings to invest in the stock.
What is a Good Price Earnings Ratio?
Analysing a company’s PE ratio by itself doesn’t provide much value. However, it does become useful to standardise the valuation of a company when compared to others in the same sector.
For example, let’s say the average PE ratio for the UK energy sector is 15.
If a UK energy stock has a PE ratio of 10 then it is considered to be undervalued relative to the overall sector and could start to outperform and catch up with the average PE ratio of the sector. This may lead to a rise in the company’s value and share price.
PE ratios will change over time as different themes affect the demand of stocks within each stock sector.
It’s worthwhile noting that PE ratios in technology companies tend to be higher as these are growth companies in which investors are willing to pay a higher earnings multiple.
The current PE ratio for Microsoft is 27.80 with its 10-year range being as high as 60.68 and as low as 10.61 providing a median range of 26.82.
The current PE ratio for Meta Platforms is 19.76 with its 10-year range being as high as 1415.5 and as low as 8.65 providing a median range of 33.67.
As Microsoft is a blue chip stock which has already experienced tremendous growth the range of earnings multiple is not as wide as Meta Platforms which is a growth stock. As Meta Platform is far below its median PE ratio there could be more growth in the stock than Microsoft which is already at its median PE ratio range over the last 10 years.
However, one reason Meta Platform is so far below its median PE ratio range is the fact its share price collapsed more than 70% from 2021 to the end of 2022. This is why the PE ratio should only be used in context with other market analysis.
Pros and Cons of the Price Earnings Ratio
The PE ratio can help to standardise the measurement of a company’s value and whether it is undervalued or overvalued relative to its industry or sector.
However, the PE ratio when used by itself doesn’t provide much value and is only useful when comparing it to another company or sector.
FAQs on Price Earnings Ratios
What is a good PE ratio?
A good PE ratio is relative to the overall sector a stock is trading in. Whether a PE ratio is high or not depends on the industry it is operating in. Growth based stocks tend to have high PE ratios while valued based stocks tend to have lower PE ratios.
Why is the P/E ratio important?
The P/E ratio is a standardised way to assess the value of a company and how much investors are willing pay for the stock per dollar or pound. It is useful to help identify if a company is undervalued or overvalued relative to the industry average.
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