What to look for in Stocks: P/E Ratio

Overview:

1. What is a Price to Earnings Ratio?

2. P/E formula and how to calculate

3. Forward P/E ratios

4. Trailing P/E ratios

5. Real Life Example of P/E ratio

6. Implications of P/E ratio

What is a Price to Earning Ratio?

The price to earning ratio is used to value a company's stock using the current price of the stock and the earnings per share(EPS) of the company. P/E ratios are generally used by investors and traders to compare the relative value of the company now, to its past or future.

P/E Ratio Formula and how to calculate it

Analysts and investors review a company's P/E ratio when they determine if the share price accurately represents the projected earnings per share.The general P/E ratio formula goes as such:

P/E Ratio= Market value per share/ Earnings per share.

The market value per share for any stock can be easily found by searching for the stock on any financial website. There are two types of EPS. One can be found with the notation "P/E (TTM),"​ This is the eps for the trailing 12 months. This number signals the company's performance over the past 12 months. The second type of EPS can be found in a company's earnings release, which often provides EPS guidance. This is the company's best-educated guess of what it expects to earn in the future. This leads us to the two types of P/E Ratios: Forward and Trailing.

Forward Price to Earnings Ratio

The forward (or leading) P/E uses future earnings guidance rather than trailing figures. Sometimes called "estimated price to earnings," this forward-looking indicator is useful for comparing current earnings to future earnings and helps provide a clearer picture of what earnings will look like – without changes and other accounting adjustments. However, an inherent consequence of this method is that companies could underestimate earnings in order to beat the estimate P/E when the next quarter's earnings are announced. Other companies may overstate the estimate and later adjust it going into their next earnings announcement.

Trailing Price to Earnings Ratio

The trailing P/E relies on past performance by dividing the current share price by the total EPS earnings over the past 12 months. It's the most popular P/E metric because it's the most objective – assuming the company reported earnings accurately. But the trailing P/E also has its share of shortcomings – namely, a company’s past performance doesn’t signal future behavior. The trailing P/E ratio will change as the price of a company’s stock moves, since earnings are only released each quarter while stocks trade day in and day out. As a result, some investors prefer the forward P/E. If the forward P/E ratio is lower than the trailing P/E ratio, it means analysts are expecting earnings to increase; if the forward P/E is higher than the current P/E ratio, analysts expect a decrease in earnings.

Example of P/E Ratio

Here is an example from investopedia.com, "As a historical example, let's calculate the P/E ratio for Walmart Stores Inc. (WMT) as of November 14, 2017, when the company's stock price closed at $91.09. The company's profit for the fiscal year ending January 31, 2017, was US$13.64 billion, and its number of shares outstanding was 3.1 billion. Its EPS can be calculated as $13.64 billion / 3.1 billion = $4.40. Walmart's P/E ratio is, therefore, $91.09 / $4.40 = 20.70x."

Implications of P/E Ratio

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends. When a company has no earnings or is posting losses, in both cases P/E will be expressed as “N/A.” Though it is possible to calculate a negative P/E, this is not the common convention