The Price-Earnings (P/E) multiple, also known as the P/E ratio, is a valuation ratio used in the finance industry that compares the price of a company’s stock to its per-share earnings.
The P/E ratio is calculated by dividing the market value per share (the current share price) by the earnings per share (EPS) over a specific period (usually the last 12 months, also known as trailing P/E, or estimated for the coming year, also known as forward P/E). This ratio is used by investors and analysts to determine the relative value of a company’s shares in an apples-to-apples comparison.
A high P/E ratio could mean that a company’s stock is over-valued, or else that investors are expecting high growth rates in the future. Conversely, a low P/E might indicate that the current stock price is low relative to earnings and the company might be undervalued, or that the company’s earnings are expected to decrease in the future.
It’s important to note that the P/E ratio should not be used in isolation and is most effective when comparing companies within the same industry. It also has its limitations as it doesn’t account for differences in growth rates between companies or differences in risk. Other factors to consider might include the company’s profit margins, the rate of sales growth, and the company’s financial health, among others.
Example of a Price-Earnings Multiple
Let’s say we have two companies in the technology industry: Company A and Company B.
Company A’s current share price is $50 and it had earnings per share (EPS) of $5 last year. To calculate the P/E ratio for Company A, we’d divide the share price by the EPS: $50 / $5 = 10. So, the P/E ratio for Company A is 10.
Now, let’s look at Company B. Its current share price is $100 and it had earnings per share (EPS) of $10 last year. Therefore, Company B’s P/E ratio is also 10: $100 / $10 = 10.
Both companies have the same P/E ratio even though Company B’s stock price and EPS are twice that of Company A. This is because the P/E ratio is a relative valuation metric, expressing how much an investor is willing to pay for each dollar of earnings.
In this example, investors are willing to pay $10 for every $1 of last year’s earnings for both Company A and Company B. If all other factors are equal, these companies could be considered similarly valued in terms of their earnings.
Of course, in reality, investment decisions should take into account a host of other factors, including future growth prospects, the stability of earnings, financial health, and more. The P/E ratio is just one tool among many that investors use to evaluate potential investments.