The price-to-earnings ratio (P/E ratio) is a measure of an organisations market value in relation to the earnings when brought down to a single unit of the asset. It often referred to as a price or an earnings multiple. The method of calculation of this metric is mentioned in our previous article. P/E ratio is often used to ascertain the relative value of an organisation, either compared to its peers or its own history. There are two broad classifications of this metric.
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Forward Price-To-Earnings Ratio
The Forward (sometimes referred to as Leading) P/E is computed using the predicted earnings of the organisation. It is a future-looking indicator and is useful to weigh current earnings against future earnings. This metric could sometimes be a bit misleading as organisations could vary the estimate of future earnings in order to showcase good numbers. The opposite is also true, where organisations overestimate their earnings and fall short. Expert analysis can also vary from the numbers offered by the company, which could lead to increased confusion.
Trailing Price-To-Earnings Ratio
This metric is quite different from the Forward P/E as it is computed using the historic performance of the organisation over the past year (twelve months). It offers an objective view of the performance of the stock – assuming that organisations report their earnings accurately. It is often trusted more than the Forward P/E as estimates can be misleading. This metric also has its fair share of shortcomings, in the sense that past performance is no guarantee of future behaviour. Also, current market events and scenarios are less visible through this metric. A relative comparison of the Forward and Trailing P/E Ratios can also tell us something about the expected performance of the stock.
Stock Valuation Based On P/E Ratio
This metric is quite widely used in the process of stock valuation. It can be used to ascertain if an organisation is over or undervalued. In addition, it can also offer a good comparison of an organisation with regard to its peers or an industry benchmark, like the S&P 500 for example.
In summary, this metric exhibits what investors are willing to pay today for an asset with regard to its historic or future earnings. Walking through an example would certainly help bring some additional clarity. Let’s compare the P/E ratios of two automotive companies, Tesla and General Motors. You can find the metric by navigating to the ‘Stats’ tab in each of the stocks. When comparing the numbers, we find that the number is quite a bit higher for Tesla than for General Motors.
This tells us that the price of the stock for Tesla is much higher when compared to the amount that the company earns, with respect to General Motors. This is possibly based on the future earnings of the companies. There could be an investor expectation that Tesla will have a higher earning in the future when compared to General Motors. It could also mean that Tesla as a company is overvalued when compared to General Motors, in today’s market.
Absolute vs Relative P/E Ratio
Absolute P/E describes what we have discussed so far, the P/E based on metrics at a given moment in time. Relative P/E is a comparison of the current P/E to a set benchmark or historical P/Es, for example, over the last 10 years. It indicates a level of success for the current P/E i.e. the potential that the current (forward) P/E will be met.
There are a few limitations of this metric. One of the biggest limitations, in this case, is the concept of a ‘negative P/E’. This can happen when the company is loss-making i.e. has negative earnings. In these cases, it becomes difficult to evaluate on the basis of this metric. In some cases, the P/E ratio is assigned to zero or N/A if the company incurs a loss. Another limitation is that there is no fixed timeline when future earnings are estimated, therefore it makes it difficult to make a good one on one comparison. In addition, there is significant variance in the metric between sectors and industries. It is also difficult to set a hard threshold for a good P/E as it greatly varies between industries and sectors.
Now that you have understood the several available metrics to analyse a stock, feel free to practice using the eToro Demo Practice Account.
This Article is Part of A Total guidance list on How to pick individual stocks, make sure you go by the article one by one to get a bigger understanding of the total picture. 😉
- How to Pick an individual stock Part 1 - The Strategy
- How to Pick an individual stock Part 2 - 5 metrics to look at when stock picking
- How to Pick an individual stock Part 3 - P/E Ratio (Price-Earnings ratio)
- How to Pick an individual stock Part 4 - Earnings Per Share
- How to Pick an individual stock Part 5 - Dividend Yield
- How to Pick an individual stock Part 6- Company History And Strength
- How to Pick an individual stock Part 7- Debt-Equity Ratio
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