Price to Earnings Ratio
Indicates if the company’s shares are under or overvalued.
How to use PE ratio
- Above 15 is considered overpriced but is hard to determine. Always compare the company to the industry mean.
- Can be very different between industries.
- Can be used to compare companies.
Why do investors use PE ratio in their analysis
The PE ratio tells investors the current sentiment in the market for that company. As with every stock, the stock price never shows the real valuation of a company but rather how the market thinks how much the stock is worth.
In other words, the current stock price also incorporates any future earnings or business opportunities in the future. The best example is the stock market crash in 2000. The PE ratio for any internet based company was going through the roof. Only based on the general assumption the internet and all associated businesses would thrive in the future. But this was based on nothing. A business still needs a good product or service to be able to survive. Instead, every investor bought any stock which did something related to the internet. Result: huge market crash.
Many investors were willing to pay premium prices and that was causing the PE ratio to rise. A high PE ratio is a warning sign that investors might be overvaluing a stock based on future earnings.
The three steps every investor should look at:
- What is the current PE Ratio?
- How does it compare to the industry?
- What is the trend?
Things to be aware of
- Only compare with other companies in the same industry.
- Some industries might have very high or very low PE ratios in general.
- PE ratios can be high for several years, it does not mean a sudden collapse is imminent.
- Earnings growth is not included in the PE ratio.
How to calculate PE ratio
- PE ratio = market value per share \ earnings per share (The market value per share is simply the current stock price. )
The PE ratio is a very commonly used ratio to determine the value of a company by comparing the current stock price relative to its earnings per share (EPS). Before we can calculate the PE ratio we need to know the EPS. EPS is calculated as follows:
- EPS = (net profit - preferred dividends) \ end of period outstanding shares.
- Net profit = revenue - expenses.
- Outstanding shares can be found in the balance sheet.
The PE value helps investors to determine if the current stock price is under or overvalued. It also projects future growth.
In general, a higher PE ratio means that investors predict higher future growth. If the PE ratio is too high, then investors expect way too much future growth the company can never fulfil. This is most likely to happen in faster moving companies like tech companies or automobile companies like Tesla. These are hot and booming markets where investors expect much future growth driven by new technology (electric cars). When looking at the current MRQ (most recent quarter) PE ratio of Tesla ( jan. 2021) it's about 247 while the average in the industry is only 6. That might be a clue that Tesla is trading for way too high prices compared to their current assets and is more based on future growth.
How you think about this?