The price/earnings ratio (P/E ratio) provides a comparison of the current market price of a share of stock and that stock's earnings per share, or EPS (which is figured by dividing a company's net income by its number of shares of common stock outstanding). For example, if a company's stock sold for $30 per share and it posted earnings per share of $1.50, that company would have a P/E ratio of 15. A company's P/E ratio typically rises as a result of increases in its stock price, an indicator of the stock's popularity.
' The price-earnings ratio is part of the everyday vocabulary of investors in the stock market," noted Richard A. Brealey and Stewart C. Myers in Principles of Corporate Finance, because a company's P/E ratio is often viewed as an indicator of future stock performance. "The high P/E shows that investors think that the firm has good growth opportunities, that its earnings are relatively safe and deserve a low capitalization rate, or both."
John B. Thomas observed in the Indianapolis Business Journal, however, that" while accepting that a high P/E ratio is usually a sign of high expectations, analysts and brokers nonetheless are quick to caution that the ratios are only part of the puzzle." A company may post an artificially high P/E ratio as a result of factors that can either boost stock prices or diminish earnings per share. Restructuring charges, merger and acquisition rumors (whether true or false), and high dividend yields all have the capacity to push a company's P/E ratio upward. In other instances, legitimately high P/E ratios can be adversely impacted down the road by such factors as market conditions, technology, and increased competition from new rivals (who may, in fact, be drawn to the industry by the company's previously posted P/E ratios).
Conversely, while a low P/E ratio is often a good indication that a company is struggling, appearances can again be deceiving. In addition, different industry sectors often have diverse P/E ratio averages. A company may have a fairly low P/E ratio when compared with all other corporations; when compared with the other companies within its industry, however, it may be a leader.
Finally, a company that posts a loss has no earnings to compare with its stock price. As a result, no P/E ratio can be determined for the company. Still, these companies may remain viable choices for investment if an investor decides that the company under examination is headed toward future profitability.
Since so many factors can influence a company's P/E ratio, industry analysts caution against relying on it too heavily in making investment decisions. As one analyst remarked to the Indianapolis Business Journal, while a company's P/E ratio is a valuable and often accurate investment tool, "if you're going to buy and sell stocks based on a P/E ratio, you're not going to make money. You'd better look at why it is high or low."
The P/E ratio became even trickier for investors to interpret in the late 1990s, as the stock market continually reached all time highs and numerous large-company stocks were traded at valuations more than two times their five-year expected growth rates. A general rule of thumb for investing states that a stock should sell at about its expected growth rate. For example, if a company's earnings were expected to grow at 12 percent per year, its stock should carry a P/E ratio of 12. "In normal times, investors preferred to buy shares in companies whose fortunes were expected to improve in coming years. They'd shop for companies whose future earnings-growth rates were expected to exceed current price/earnings multiples," Gretchen Morgenson wrote in Forbes. "But these are not normal times. The folks who are buying these shares are closing their eyes to ordinary standards of value. Call them see-no-evil stocks."
As an example, Morgenson noted that Procter & Gamble shares were trading at 28 times the company's latest 12-month earnings as of late 1997, and this high figure was hardly exceptional. While some analysts argued that the high P/E ratios were justified due to falling long-term interest rates and low inflation, others warned that they left no room for a downturn in earnings at the companies boasting high stock prices. "Buying overpriced stocks because you think they'll become even more expensive—the Greater Fool theory—has worked out pretty well in recent markets," Morgenson admitted. "But don't bet on it continuing to work forever. As the P/Es mount higher, the game gets riskier."
Earnings per share is one of the two factors that determine a company's P/E ratio; the other is the price of the company's stock. EPS is derived by dividing a corporation's net income by the number of shares of common stock that are outstanding. A company with 30,000 outstanding shares of common stock and a net income of $270,000 would thus have an earnings per share of $9.
An essential part of determining the P/E ratio, earnings per share has also come to be regarded as an important piece of information for the investment community in and of itself. "A primary concern of investors is how profitable a company is relative to their investment in the company," wrote Jay M. Smith Jr. and K. Fred Skousen in Intermediate Accounting. "The investor is concerned with how net income relates to shares held and to the market price of the stock.… Only by converting the total amounts to per share data can a meaningful evaluation be made," because EPS figures can illustrate the degree to which a company's net income is keeping pace with its capital structure. In recognition of the importance of this information, corporations are required to report EPS amounts on their income statement (the requirement was suspended for nonpublic entities in 1978).
[ Laurie Collier Hillstrom ]
Bierman, Harold, Jr., and Seymour Smidt. Financial Management for Decision Making. New York: Macmillan, 1986.
Brealey, Richard A., and Stewart C. Myers. Principles of Corporate Finance. 5th ed. New York: McGraw-Hill, 1996.
"Don't Get Burned by Hot Stocks." Money, October 1994,72.
Ip, Greg. "The New Math: Are Some High P/E Stocks 'Bargains'?" Wall Street Journal, 1 December 1997, Cl.
Laderman, Jeffrey M. "They're Not as Loony as They Look: P/E Ratios Are Loftier than Ever, but Don't Bail Out Just Yet." Business Week, 18 May 1998, 148.
Morgenson, Gretchen. "See-No-Evil Stocks." Forbes, 22 September 1997, 252.
Smith, Jay M., Jr., and K. Fred Skousen. Intermediate Accounting. 9th ed. Cincinnati: South-Western Publishing, 1987.
Thomas, John B. "P/E Ratios Driven by Variety of Factors, Carry Variety of Meanings." Indianapolis Business Journal, 23 May 1994, 10B.