This is a part of the Investing Series.
PRICE TO EARNINGS (P/E) RATIO = GROWTH OF A COMPANY
This particular multiple looks at how the company is growing its earnings compared to the price of the stock or its “rate of return”.
You can think of it as how much money you are making individually with your stocks in relation to how much the company is able to earn as a whole.
There are a number of ways you can calculate this with different sorts of numbers, because you can use this ratio to calculate what you THINK it might earn (also known as “projected income”), or what it has actually earned (also known as “realized income”).
CALCULATING A P/E RATIO (STANDARD)
This is just the base calculation of a P/E ratio:
Market Value per share / Earnings per share (EPS)
If a company’s market value per share is $10, and their EPS is $2 the calculation is:
$10 / $2 = 5
This means that for each share, its P/E ratio is 5.
(Scroll down for what the range of numbers mean.)
WHAT IS MARKET VALUE PER SHARE?
It’s the price of the stock, today, right now… or its “market value”.
WHAT IS EARNINGS PER SHARE?
EPS generally means how much profit is made by the company, divided out by its investors.
Taking a really simple example, let’s say a single mom works full-time and her income brings home $30,000 net a year.
As she’s a single mom with 2 kid, she has 3 mouths to feed (hers, and her 2 kids), so her earnings per share would be $10,000 a year, per person in the household.
Now this is not really true because she won’t be literally giving $10,000 to each child, but her resources are spread out over 2 dependent children who don’t contribute to the household, so she’s sharing her ability to pay for rent, food, utilities, etc.
HOW TO CALCULATE EARNINGS PER SHARE (EPS)
Back to a company.
You want to know how to calculate earnings per share, so that you know how much PROFIT the company is making, per share it has issued to each shareholder.
The calculation is:
( Net Income – Dividends on Preferred Shares ) / Number of Outstanding (or Issued) Shares
The calculation takes into account that the company makes a NET income (that is, after taxes and other expenses), and if we remove dividends, we have their “true” net income to spread out among the common shareholders.
WHAT IS THE DIFFERENCE BETWEEN PREFERRED AND COMMON STOCK?
It is as it says.
There is a class difference in stocks, much like buying a seat on an airplane. You can choose to pay more and fly Business class, or sit in Economy with the rest of us.
Technically speaking if the plane goes down, it won’t matter where you’re seated 😛 , but assuming things go fine and dandy on the plane, Business class passengers get free alcohol, snacks, hot towels, magazines, drinks and all the pampering that Economy class passengers don’t get.
Stocks work the same way.
Preferred shareholders get paid first before common shareholders.
They are #1 in line for boarding the plane, and they are #1 in line in the event the company has to be broken down and sold for parts to pay its creditors, and shareholders are creditors in a way because we’re lending money to the company to let them use it in exchange for return on our money.
CALCULATING VARIATIONS OF THE P/E RATIO WITH “NET INCOME”
You will notice above, that I said “net income” goes into the EPS calculation, but I didn’t tell you how to calculate the net income.
It’s because what you choose to consider “net income”, is up to you.
Here are the three most common ways to calculate “Net Income” to use as a number in EPS:
- Trailing or “Standard” P/E — Past 12 months or 4 quarters for “net income”
- Forward or Projected P/E — Projected next year, 12 months or 4 quarters of “net income”
- Hybrid P/E — Past 6 months or 2 quarters, and the future 6 months or 2 quarters = 4 quarters
1. TRAILING P/E (“STANDARD” P/E)
I like to call this one the “standard P/E” in my head (not an official term!!) because it’s the one most people calculate by taking the past 12 months of a company’s earnings.
It just looks at the past 12 months or 4 quarters of what the company earned as a net income, and uses THAT number.
So if a company has consistently earned $10 million in the past, you can use that number in your future calculations.
2. FORWARD OR PROJECTED P/E
You calculate which net income number to use by looking at the FUTURE 4 quarters or 12 months of the company’s earnings.
Some say it’s riskier because you don’t really know if they’ll hit those targets or not.
Some say it’s just as risky as looking at the past because the past doesn’t really tell you whether or not a stock will go up or down.
It’s already done and what you care about is what’s GOING to happen.
So if a company has consistently earned $10 million in the past, but is projected to double that for next year due to a new contract they just negotiated, you can use $20 million as your net income for your calculations.
3. HYBRID P/E
A mix of the two — you look at the past 2 quarters or the most recent 6 months of net income made by the company, and you take the future 2 quarters or projected 6 months of the future, expected net income.
WHICH P/E DO I CHOOSE, THEN?
It’s up to you.
Do you want to look at the past? The future? Or a hybrid of both?
It’s up to you to decide what you think makes sense based on what you’ve read about the company and learned.
OKAY OKAY FINE.. BUT WHAT DO THE NUMBERS OR RATIOS MEAN?
Once you get a P/E ratio, you can look at a chart similar to this one to see if it’s a good deal or grossly overvalued.
Again, these numbers are both GOOD and BAD. You can interpret them EITHER WAY.
You don’t necessarily have to choose a P/E of a company that is always below 10 to get a good stock.
It all hinges on what your investing strategy is — do you look for cheap stocks trading below book value? Or do you want a stock that has a future growth an a high P/E to reflect that?
- 0-10 = It’s either an amazing deal, or the company is on its way down to oblivion
- 10-17 = A good “fair value” to buy the company at
- 17-25 = Not a good deal; the company’s stock price is higher than what it’s really worth or it is on its way up in terms of growth
- 25+ = It’s extremely overvalued and is really on its way up in terms of future projected growth, or the company just had a bad year in earnings but will go up next year
As you can see, even calculating a ratio like this to get a ‘hard’ number, you still have to interpret it based on what you’ve learned about the company itself.
DON’T JUST LOOK AT ONE RATIO AND CALL IT A DAY
A competitor with a P/E of 10 may look like a great deal compared to another with a P/E of 25, however maybe that competitor is about to go bankrupt due to other reasons.
You don’t know until you do your base analysis and then research on top of that.
This is just ONE number, and it’s very risky to base your analyses on ONE number as you don’t get to see the whole picture.
- P/E ratio is calculated by taking market value of the share divided by profit earned per share
- As P/E ratios use Earnings per Share (EPS) in its calculation, it is up to interpretation…
- …because you can choose HOW you want to calculate “net income” to use in calculating EPS
- 3 Net Income calculations: Past 4 Quarters, Future 4 Quarters or a Hybrid of the Past & Future
- This is just ONE calculation in a range of many you can use