Price/Earnings (P/E) Ratio

Price/Earnings or P/E ratio is the ratio of a company's share price to its earnings per share. It tells whether the share price of a company is fairly valued, undervalued or overvalued.

Formula

P/E Ratio = Current Share Price
Earnings per Share

Current share price is obtained from secondary markets like NYSE, NASDAQ, etc. while EPS is calculated as (net income minus preferred dividends)/weighted average number of shares outstanding.

Leading and Trailing P/E Ratio

If the EPS is the figure for the current period the P/E ratio is called trailing P/E ratio. For better analysis the EPS should be the one expected to prevail in the next reporting period, say next year. P/E ratio calculated based on expected P/E ratio is called leading P/E and is a more meaningful estimate of the company's justified P/E ratio.

Analysis

For financial analysis justified P/E ratio is calculated using dividend discount method.

P/E Ratio = Expected Payout Ratio
Required Rate of Return − Dividend Growth Rate

If the justified P/E calculated using dividend discount analysis is higher than the current P/E ratio the share is undervalued and should be purchased. If the justified P/E is lower than P/E ratio the share is overvalued and should be sold.

Example

A share of T Ltd. has current market price of $20 and it's EPS for current period is reported as $2. It's EPS for next period is expected as $2.5, expected payout ratio is 40%, required rate of return is 12% and growth rate is 6%. Find the trailing P/E, leading P/E and justified P/E.

Solution

Trailing P/E = current share price/current year EPS = $20/$2 = 10
Leading P/E = current share price/next year EPS = $20/$2.5 = 8
Justified P/E = payout ratio/(required rate of return − growth rate) = 40%/(12% − 6%) = 40%/6% = 6.67

Reciprocal of P/E ratio is called earnings yield (which is EPS/price).

Written by Obaidullah Jan