The price-to-earnings ratio, commonly known as the P/E ratio, is one of the most widely used valuation metrics. It is a basic measure used to compare different investments or the same investment over different periods of time, and it’s simple to calculate.
The P/E ratio is most commonly used for a quick comparison between two securities to see how Wall Street values them, with a higher P/E suggesting that future earnings are more likely. Dividing the common stock market share price (numerator) by earnings per share (denominator) produces the ratio. For example, a stock with a market price of $15.00 and earnings of $1.00 per share would have a P/E ratio of 15 (15/1=15).
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P/E ratios can be calculated on past or realized earnings, projected earnings, or a combination of each. Earnings are sometimes adjusted to exclude extraordinary events, since they are unlikely to repeat. When considering P/E ratios, it is important to understand if and how earnings have been adjusted and whether they are actuals or projections.
Examples of different P/E types include:
Trailing or Current P/E
Analysts use earnings for the most recent 12-month period. As each quarter is completed, the oldest quarter’s earnings per share is dropped and the most recent quarter is added to the total.
Projected or Forward P/E
The divisor is the projected or estimated earnings per share over the next 12 months. The estimate may be that of a single analyst or the consensus estimate from a group of analysts. It is important to know the identity and qualifications of the analysts providing an estimate to determine whether it is realistic.
Combined or Mixed P/E
Some analysts use a combination of the two last quarters of actual earnings plus the first two quarters of projected earnings as the divisor.
Regardless of which type of P/E you use, it’s important to be consistent when comparing period to period or one company’s stock with that of another. Since analysts have broad discretion in choosing what numbers they use to calculate P/E ratios, you should not be surprised that the ratios commonly vary from analyst to analyst or firm to firm. Be careful that you don’t compare apples to oranges.
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