Price-to-Earnings Ratio (P/E)

Price-to-Earnings Ratio Formula

Forward Price-to-Earnings Ratio and Trailing Price-to-Earnings Ratio

The price-to-earnings ratio (P/E ratio) is commonly calculated using either historical or forward-looking data. When calculated using forward-looking data, it is referred to as the forward P/E ratio or estimated P/E ratio. This version of the ratio utilizes future earnings projections for the next 12 months. It is helpful for comparing current earnings to anticipated future earnings. However, the accuracy of the projections greatly influences the reliability of this indicator. Another variation of the P/E ratio is the price-to-earnings growth ratio (PEG). The PEG ratio allows investors to assess whether a stock is overvalued or undervalued by considering both current earnings and the expected future growth rate of the company.

On the other hand, the trailing P/E ratio is based on historical performance. It is calculated by dividing the current stock price by the total earnings per share (EPS) of the past 12 months. The reliability of this indicator depends on the accuracy of the financial statements and the reported earnings. One advantage of this approach is that it does not rely on projections. However, it's important to note that past performance may not always be an accurate predictor of the future. Sudden events within a company can significantly impact the stock price, which may not be fully reflected in the trailing P/E ratio.

Analysts generally anticipate increasing earnings when the forward P/E ratio is lower than the trailing P/E ratio.

Example: Valuation Using the P/E Ratio

The price-to-earnings ratio (P/E ratio) represents the amount an investor currently needs to invest in a company to receive one unit of its earnings (in the current year). In other words, the P/E ratio indicates the investor's willingness to pay for one unit of earnings. For example, if a company is currently traded with a P/E ratio of 10, it means that an investor is willing to pay, let's say, CHF 10 for CHF 1 of current earnings. The P/E ratio reflects what the market is willing to pay for a stock based on its past and future earnings. A high P/E ratio may indicate that the stock's price is high relative to its earnings and thus overvalued. Conversely, a low P/E ratio may suggest that the current stock price is low relative to its earnings.

Let's consider an example: Suppose a stock closes at a price of CHF 100. The company's earnings at the end of the fiscal year amounted to CHF 15 billion, and the number of outstanding shares stood at 3 billion.

The earnings per share (EPS) is calculated by dividing the earnings by the number of shares. In this example, the EPS is CHF 5 (= 15 billion / 3 billion). The P/E ratio is calculated as follows:

This implies that investors are willing to pay CHF 20 for each CHF 1 of the company's earnings in that period. In other words, it would take the company 20 years to earn back the invested capital at the current earnings level. Generally, a high P/E ratio indicates that investors anticipate higher future earnings growth compared to companies with lower P/E ratios. On the other hand, a low P/E ratio can suggest that a company is currently undervalued or outperforming its past performance.

It's important to note that a low P/E ratio can either indicate a stock is attractively priced or suggest expectations of weak or negative earnings growth. Conversely, a high P/E ratio does not necessarily mean that a stock is overvalued. A prudent wealth manager considers other factors, such as analyzing industry trends, alongside the P/E ratio when making investment decisions.