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The Variables Affecting the Price Earnings Ratio

Original post by Jonathan Langsdorf of Demand Media

The price-to-earnings ratio allows investors to compare values of different stocks.

The price-to-earnings -- P/E -- ratio is a commonly used stock-valuation indicator. The P/E ratio is so widely used it is included in the data when you research a stock price using any of the major stock-market information websites. An investor who understands the factors affecting the P/E ratio will be better able to evaluate stock prices.

Calculating P/E

Calculate a price-to-earnings ratio by dividing the current share price by the earnings per share for the previous 12 months. For example, if a stock is priced at $50 and the earnings per share were $2, the P/E of the stock is 25. The ratio can be used to compare stocks with widely different share prices. A $100 stock with a 25 P/E and a $10 stock with the same ratio have a comparable valuation.

Earnings

The earnings used to calculate the standard P/E ratio are the earnings for the previous 12 months. In most cases, the quarterly net earnings per share for the four most recently reported quarters are totaled. The earnings number used to calculate the P/E ratio is updated only once every three months. Using historic earnings means the P/E ratio is a backwards looking indicator, while the stock market tends to look forward. Some investors will calculate a forward P/E ratio using the projected earnings for the upcoming year. To use this approach, the investor must remember actual earnings earnings results may be significantly different than the estimates.

Stock Price

The stock price is the top number in the P/E calculation and is a value in constant fluctuation. The possibility of a share price to change significantly in either direction means a P/E ratio is a snapshot based on the current share price. If the share price increases, the P/E ratio will rise. A falling share price results in a lower price-to-earnings ratio.

Market Expectations

Stocks will have widely different price-to-earnings ratios depending on the market belief concerning the future profit growth of a stock. The P/E ratio can be viewed as a rough estimate of the earnings-growth rate. For example, at the time of publication, Apple, stock symbol AAPL, was trading at a P/E of about 16. Competitor Hewlett-Packard, symbol HPQ, had a P/E multiple of 8. These different ratios indicate the market expects earnings at Apple to grow significantly faster than the earnings for Hewlett-Packard.

                   

References

About the Author

Jonathan Langsdorf has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Langsdorf has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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