PE, or Price to Earnings ratio is a measure of a company’s price, relative to it’s earnings. It can either be measured as a forward looking metric or a backwards looking metric.
To calculate the PE of a company, you divide it’s Market Capitalization (MC) by it’s earnings, or Net Income – Dividends. To calculate the forward PE, you use projected earnings (forecast by you or the company); to calculate the backwards PE, you use the earnings from the most recent financial report.
PE is a sort of valuation method to see if a company is worth investing in at it’s current price. You can think of the PE as the number of years you’d have to own a share in the company before the company earned enough money to cover the cost if your purchase (assuming earnings are the same each year).
For example, if a company’s MC is $100M and it’s earnings are $10M, the PE would be 10 (100 / 10 = 10). After 10 years of earning $10M, the company would have made $100M (excluding amortization & interest on the value of the money).
Assuming all this money is paid out in dividends, the investor would have made their money back. In this scenario, a PE of 10 might be considered as a 10% ROI.
Depending on several factors, such as risk, market sentiment, the growth rate of a company and expected return, an investor might be willing to buy a company at a higher or lower PE.
A fair PE for a company with zero annual growth might be 11, while a company growing at a fast rate might command a higher PE, such as 25 – 40. The PE that you are willing to accept is directly related to the amount of return you want to achieve on your investment – it is this factor that brings market sentiment into the equation.
It’s worth considering that this method of calculating value in a stock price doesn’t consider growth of a company sourced from investing profits back into the company before realizing them on a balance sheet, which is a tax efficient way to grow the company. PE is more suited to valuing mature companies, or growth companies with a significant profit margin. PE also doesn’t show value in a company that is not profitable.
This method is a provides a very real perspective of the Return On Investment (ROI) because it considers the part of the profits that are held by the company – though it’s important to ensure that if those profits which were held back are reinvested, that they do actually translate into growth. Otherwise they are just a poorly reported costs of doing business.
Finally, please feel free to check out my own proprietary method for calculating PE.