By Hrishikesh Menon. Edited by Swastik Patel
Regardless of whether you have knowledge about stocks, you may have heard of the price-to-earnings ratio. It is one of the most common valuation metrics used to evaluate the financial health of a company and determine the fair value of its shares. Let’s get a better look at how exactly this is done.
The formula for annual P/E is simply the market cap of the company divided by the latest reported annual net profit or earnings. Additionally, there are many different versions of P/E ratios based on the earnings time period, which are divided into either trailing or forward P/E ratios. Trailing P/E takes past earnings into account, and forward P/E is based on earnings projections. For example, a very common ratio is the 12-month trailing P/E ratio which is the market cap divided by the earnings of the past 12 months. Similarly, the 12-month forward P/E ratio is based on the earnings projection for the next 12 months.
As an investor, the P/E ratio of a company tells you how much you need to invest in order to get $1 of the company’s earnings. Therefore, a low P/E ratio is optimal as it indicates that the company may be undervalued. To further justify that the stock is undervalued, more due diligence is required (reading 1ok, finding a sustainable moat, growth, etc). A low P/E ratio usually indicates that the company or the whole sector is stable and mature, which is the perfect situation for value investors who are looking for high returns in the next 5-10 years. . However, many long-term investors, especially in the past 40 years, allow some leeway on the P/E ratio and invest in companies with relatively high P/E ratios. This is mostly seen in the technology sector, the fastest-growing sector of the past 20 years. Tech giants such as Apple, Microsoft, and Facebook have P/E ratios ranging from 25 to 30, which is high considering that most blue-chip companies tend to have a ratio closer to 13. Does this mean that those three companies are overvalued? Perhaps, but investors are willing to pay a slight premium because they realize those companies have strong moats and will be around for a long time. Due to the rapid growth of the tech sector, there are many other tech giants with egregiously high P/E ratios such as Tesla, Autodesk, and Roku, which have ratios close to 100. These are examples of stocks that are clearly overvalued. These three companies are strong with growing fundamentals, but the stock price growth exceeded the fundamental growth due to speculative investing fueled by the greatest bull market since 2009.
ConclusionThe price-to-earnings ratio, or the P/E ratio, is the market cap of the company divided by the earnings over a period of time (quarterly, annual, five years, etc). It indicates the amount the investor must pay to get $1 in the company’s profits. The lower, the better, although a slightly higher P/E is justifiable if the company has strong growth fundamentals. If the stock price is growing faster than the fundamentals, the P/E will be very high, which is a clear sign of overvaluation. Finally and most importantly, the P/E ratio is a mere indicator of whether a company’s price is justified; it does not solely determine the value of the company. Thorough research of the company’s fundamentals is required to determine the fair value and P/E is only a part of it.