The
P/E ratio of a
stockThe capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
(also called its "P/E", or simply "multiple") is a measure of the price paid for a
shareA joint stock company divides its capital into units of equal denomination. Each unit is called a share. These units are offered for sale to raise capital. This is termed as issuing shares. A person who buys share/shares of the company is called a shareholder, and by acquiring share or shares in...
relative to the annual
net incomeNet income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
or
profitIn accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
earned by the firm per share. The P/E ratio can therefore alternatively be calculated by dividing the company's
market capitalizationMarket capitalization is a measurement of the value of the ownership interest that shareholders hold in a business enterprise. It is equal to the share price times the number of shares outstanding of a publicly traded company...
by its total annual earnings.
Unlike the
EV/EBITDAEV/EBITDA is a valuation multiple used in finance and investment to measure the value of a company. This important multiple is often used in conjunction with, or as an alternative to, the P/E ratio to determine the fair market value of a company.An advantage of this multiple is that it is capital...
multiple which is
capital structureIn finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
-neutral, the price-to-earnings ratio reflects the
capital structureIn finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
of the company in question. The price-to-earnings ratio is a
financial ratioA financial ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization...
used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is
more expensive compared to one with a lower P/E ratio. The P/E ratio can be seen as being expressed in
years,
[Price is in currency or currency/share, while earnings are in currency/year, or currency/share/year.] in the sense that it shows the number of years of earnings which would be required to pay back purchase price, ignoring inflation and time value of money. The P/E ratio also shows current investor demand for a company share.
The
reciprocalIn mathematics, a multiplicative inverse or reciprocal for a number x, denoted by 1/x or x−1, is a number which when multiplied by x yields the multiplicative identity, 1. The multiplicative inverse of a fraction a/b is b/a. For the multiplicative inverse of a real number, divide 1 by the...
of the P/E ratio is known as the
earnings yieldEarnings yield is the quotient of earnings per share divided by the share price. It is the reciprocal of the P/E ratio.The earnings yield is quoted as a percentage, allowing an easy comparison to going bond rates.-Applications:...
. The earnings yield is an estimate of the expected return from holding the stock if we accept certain restrictive assumptions (a discussion of these assumptions can be found here).
Definition
The P/E ratio is defined as:
-
-
However, the definition of its components may vary.
The price per share in the numerator is the
market priceIn economics, market price is the economic price for which a good or service is offered in the marketplace. It is of interest mainly in the study of microeconomics...
of a single share of the stock. The
earnings per shareEarnings per share is the amount of earnings per each outstanding share of a company's stock.In the United States, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations,...
in the denominator depends on the type of P/E:
- "Trailing P/E" or "P/E ttm": Here earnings per share
Earnings per share is the amount of earnings per each outstanding share of a company's stock.In the United States, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations,...
is the net incomeNet income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
of the company for the most recent 12 month periodThe trailing twelve months is a measurement of a company's financial health used in finance. Using the income statements from a company's reports , it calculates the income for the twelve-month period immediately prior to the date the report...
, divided by the number of shares issued. This is the most common meaning of "P/E" if no other qualifier is specified. Monthly earning data for individual companies are not available, so the previous four quarterly earnings reports are used and earnings per shareEarnings per share is the amount of earnings per each outstanding share of a company's stock.In the United States, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations,...
are updated quarterly. Note, each company chooses its own financial year so the timing of updates will vary from one to another.
- "Trailing P/E from continued operations": Instead of net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
, this uses operating earnings, which exclude earnings from discontinued operations, extraordinary items (e.g. one-off windfalls and write-downs), or accounting changes. Note, longer-term P/E data, such as Shiller's, use net earnings.
- "Forward P/E", "P/Ef", or "estimated P/E": Instead of net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
, this uses estimated net earnings over next 12 months. Estimates are typically derived as the mean of a select group of analysts (note, selection criteria is rarely cited). In times of rapid economic dislocation, such estimates become less relevant as the situation changes (e.g. new economic data is published, and/or the basis of forecasts becomes obsolete) more quickly than analysts adjust their forecasts.
For example, if stock A is trading at $24 and the earnings per share for the most recent 12 month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of the stock is paying $8 for every dollar of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio (usually shown as Not applicable or "N/A"); sometimes, however, a negative P/E ratio may be shown.
By comparing price and earnings per share for a company, one can analyze the market's
stock valuationIn financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally potential market prices, and thus to profit from price movement – stocks that are judged...
of a company and its shares relative to the income the company is actually generating. Stocks with higher (and/or more certain) forecast
earnings growthEarnings growth is the annual rate of growth of earnings from investments.-Overview:Generally, the greater the earnings growth, the better.When the dividend payout ratio is the same, the dividend growth rate is equal to the earnings growth rate....
will usually have a higher P/E, and those expected to have lower (and/or riskier) earnings growth will usually have a lower P/E. Investors can use the P/E ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal (especially the
earnings growthEarnings growth is the annual rate of growth of earnings from investments.-Overview:Generally, the greater the earnings growth, the better.When the dividend payout ratio is the same, the dividend growth rate is equal to the earnings growth rate....
rate), it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, companies, and time periods may be misleading.P/E ratio in general is useful for comparing valuation of peer companies in similar sector or group.
Since 1900, the average P/E ratio for the
S&P 500The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
index has ranged from 4.78 in Dec 1920 to 44.20 in Dec 1999, with an average around 15. The average P/E of the market varies in relation with, among other factors, expected growth of earnings, expected stability of earnings, expected inflation, and yields of competing investments. For example, when US treasury bonds yield high returns, investors pay less for a given
earnings per shareEarnings per share is the amount of earnings per each outstanding share of a company's stock.In the United States, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations,...
and P/E's fall.
Determining share prices
Share prices in a publicly traded company are determined by market
supply and demandSupply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
, and thus depend upon the expectations of buyers and sellers. Among these are:
- The company's future and recent performance, including potential growth;
- Perceived risk, including risk due to high leverage
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
;
- Prospects for companies of this type, the market sector
The term market sector is used in economics and finance to describe a set of businesses that are buying and selling such similar goods and services that they are in direct competition with each other...
.
By dividing the price of one share in a company by the profits earned by the company per share, the P/E ratio is obtained. If earnings per share move proportionally with share prices the ratio stays the same. But if stock prices gain in value and earnings remain the same or go down, the P/E rises.
The earnings figure used is the most recently available, although this figure may be out of date and may not necessarily reflect the current position of the company.
This is often referred to as a 'trailing P/E', because it involves taking earnings from the last four quarters.
Other related measures
The
forward P/E uses the estimated earnings going forward twelve months.
P/E10 uses average earnings for the past 10 years. There is a view that the average earnings for a 20 year period remains largely constant, thus using P/E10 will reduce the noise in the data.
The P/E ratio relates to the
equity valueEquity value is the value of a company available to owners or shareholders. It is the enterprise value plus all cash and cash equivalents, short and long-term investments, and less all short-term debt, long-term debt and minority interests....
. A similar measure can be defined for real estate, see
Case-Shiller index.
PEG ratioThe PEG ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share , and the company's expected growth....
is obtained by dividing the P/E ratio by the annual earnings growth rate. It is considered a form of normalization because higher growth rate should cause higher P/E.
The similar ratio on the
enterprise valueEnterprise value , Total enterprise value , or Firm value is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others...
level is
EV/EBITDAEV/EBITDA is a valuation multiple used in finance and investment to measure the value of a company. This important multiple is often used in conjunction with, or as an alternative to, the P/E ratio to determine the fair market value of a company.An advantage of this multiple is that it is capital...
Enterprise valueEnterprise value , Total enterprise value , or Firm value is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others...
divided by the EBITDAEBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization. It is a non-GAAP metric that is measured exactly as stated. All interest, tax, depreciation and amortization entries in the income statement are reversed out from the bottom-line net income...
.
Present Value of Growth Opportunities (PVGO) is another alternative method for stock valuation. Present value of growth opportunities is calculated by finding the difference between price of equity with constant growth and price of equity with no growth.
- PVGO = P(Growth) - P(No growth) = [D1/(r-g)] - E/r
where
- D1 = Dividend for next period
- r = Cost of Capital or the capitalization rate of the company
- E = Earning on equity
- g = The growth rate of the company.
Since the Price/Earnings (P/E) Multiple is 'Price per share / Earnings per share' it can be written as
- P0 / E1 = 1/r [ 1+ (PVGO/(E1/r))].
Thus, as PVGO rises, the P/E ratio rises.
Earnings yield
The reverse (or reciprocal) of the P/E is the E/P, also known as the
earnings yieldEarnings yield is the quotient of earnings per share divided by the share price. It is the reciprocal of the P/E ratio.The earnings yield is quoted as a percentage, allowing an easy comparison to going bond rates.-Applications:...
. The earnings yield is quoted as a percentage, and is useful in comparing a
stockThe capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
, sector, or the
market'sA stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...
valuation relative to
bondsIn finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
.
The earnings yield is also the cost to a publicly traded company of raising expansion capital through the issuance of stock.
Its computed as (EARNINGS PER SHARE/MARKET PRICE PER SHARE)
Price/dividend ratio
Publicly traded companies often make periodic quarterly or yearly cash payments to their owners, the shareholders, in direct proportion to the number of shares held. According to US law, such payments can only be made out of current earnings or out of reserves (earnings retained from previous years). The company decides on the total payment and this is divided by the number of shares. The resulting
dividendDividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
is an amount of cash per share.
Just as P/E is the ratio of price to earnings, the Price/Dividend ratio is the ratio of price to dividend.
Dividend yield
The
dividend yieldThe dividend yield or the dividend-price ratio on a company stock is the company's total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage...
is the dividend paid in the last accounting year divided by the current share price: it is the reciprocal of the Price/Dividend ratio.
If a stock paid out $5 per share in cash dividends to its shareholders last year, and its price is currently $50, then it has a dividend yield of 10%.
Historically, stocks with very high P/E ratios pay little if any dividends. Theoretically speaking, if the dividend exceeds the earnings, the company may be seen as returning capital to its investors, a situation that can not persist indefinitely.
Relationship between measures
Several of these measures are related to each other: given price, earnings, and dividend, there are 6 possible ratios, which come in reciprocal pairs:
- P/E ratio and earnings yield are reciprocals;
- P/D ratio and dividend yield are reciprocals;
- Dividend payout ratio (DPR) = Dividend/EPS, while the reciprocal is dividend cover
Dividend cover is the ratio of company's earnings over the dividend paid to shareholders, calculated as earnings per share divided by the dividend per share...
(DC) = EPS/Dividend.
They are related by the following equations:
- P/E = P/D * DPR and P/D = P/E * DC;
- taking reciprocals, earnings yield = dividend yield * DC and dividend yield = earnings yield * DPR.
Interpretation
The
averageIn mathematics, an average, or central tendency of a data set is a measure of the "middle" value of the data set. Average is one form of central tendency. Not all central tendencies should be considered definitions of average....
U.S. equity P/E ratio from 1900 to 2005 is 14 (or 16, depending on whether the
geometric meanThe geometric mean, in mathematics, is a type of mean or average, which indicates the central tendency or typical value of a set of numbers. It is similar to the arithmetic mean, except that the numbers are multiplied and then the nth root of the resulting product is taken.For instance, the...
or the
arithmetic meanIn mathematics and statistics, the arithmetic mean, often referred to as simply the mean or average when the context is clear, is a method to derive the central tendency of a sample space...
, respectively, is used to average).
Normally, stocks with high earning growth are traded at higher P/E values. From the previous example, stock A, trading at $24 per share, may be expected to earn $6 per share the next year. Then the forward P/E ratio is $24/6 = 4. So, an investor is paying $4 for every $1 of earnings, which makes the stock more attractive than it was the previous year.
The P/E ratio implicitly incorporates the perceived risk of a given company's future earnings. For a stock purchaser, this risk includes the possibility of
bankruptcyBankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
. For companies with high
leverageIn finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
(that is, high levels of debt), the risk of bankruptcy will be higher than for other companies. Assuming the effect of leverage is positive, the earnings for a highly-leveraged company will also be higher. In principle, the P/E ratio incorporates this information, and different P/E ratios may reflect the structure of the
balance sheetIn financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
.
Variations on the standard trailing and forward P/E ratios are common. Generally, alternative P/E measures substitute different measures of earnings, such as rolling averages over longer periods of time (to "smooth" volatile earnings, for example), or "corrected" earnings figures that exclude certain extraordinary events or one-off gains or losses. The definitions may not be standardized.
Various interpretations of a particular P/E ratio are possible, and the historical table below is just indicative and cannot be a guide, as current P/E ratios should be compared to current
real interest rateThe "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...
s (see
Fed modelThe "Fed model" is a theory of equity valuation that has found broad application in the investment community. The model compares the stock market’s earnings yield to the yield on long-term government bonds...
):
| N/A |
A company with no earnings has an undefinedIn mathematics, division by zero is division where the divisor is zero. Such a division can be formally expressed as a / 0 where a is the dividend . Whether this expression can be assigned a well-defined value depends upon the mathematical setting...
P/E ratio. By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, even though a negative P/E ratio can be mathematically determined. |
| 0–10 |
Either the stock is undervalued or the company's earnings are thought to be in decline. Alternatively, current earnings may be substantially above historic trends or the company may have profited from selling assets. |
| 10–17 |
For many companies a P/E ratio in this range may be considered fair value. |
| 17–25 |
Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published. The stock may also be a growth stock In finance, a growth stock is a stockof a company that generates substantial and sustainable positive cash flow and whose revenues and earnings are expected to increase at a faster rate than the average company within the same industry...
with earnings expected to increase substantially in future. |
| 25+ |
A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...
bubbleA stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation....
. |
It is usually not enough to look at the P/E ratio of one company and determine its status. Usually, an analyst will look at a company's P/E ratio compared to the
industryIndustry refers to the production of an economic good or service within an economy.-Industrial sectors:There are four key industrial economic sectors: the primary sector, largely raw material extraction industries such as mining and farming; the secondary sector, involving refining, construction,...
the company is in, the sector the company is in, as well as the overall market (for example the
S&P 500The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
if it is listed in a US exchange). Sites such as
ReutersReuters is a news agency headquartered in New York City. Until 2008 the Reuters news agency formed part of a British independent company, Reuters Group plc, which was also a provider of financial market data...
offer these comparisons in one table.
Example of SPY Often, comparisons will also be made between quarterly and annual data. Only after a comparison with the industry, sector, and market can an analyst determine whether a P/E ratio is high or low with the above mentioned distinctions (i.e., undervaluation, over valuation, fair valuation, etc.).
Using
Discounted cash flowIn finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
analysis, the impact of earnings growth and inflation can be evaluated. Using constant historical
earnings growthEarnings growth is the annual rate of growth of earnings from investments.-Overview:Generally, the greater the earnings growth, the better.When the dividend payout ratio is the same, the dividend growth rate is equal to the earnings growth rate....
rate of 3.8 and post-war
S&P 500The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
returns of 11% (including 4% inflation) as the discount rate, the fair P/E is obtained as 14.42. A stock growing at 10% for next 5 years would have a fair P/E of 18.65.
The market P/E
To calculate the P/E ratio of a market index such as the S&P 500, it is not accurate to take the "simple average" of the P/Es of all stock constituents; since it is a capitalization-weighted index, the accurate method is to calculate a
weighted averageThe weighted mean is similar to an arithmetic mean , where instead of each of the data points contributing equally to the final average, some data points contribute more than others...
. In this case, each stock's underlying market cap (price multiplied by number of shares in issue) is summed to give the total value in terms of market capitalization for the whole market index. The same method is computed for each stock's underlying net earnings (earnings per share multiplied by number of shares in issue). In this case, the total of all net earnings is computed and this gives the total earnings for the whole market index. The final stage is to divide the total market capitalization by the total earnings to give the total market P/E ratio. The reason for using the weighted average method rather than 'simple' average can best be described by the fact that the smaller constituents have less of an impact on the overall market index. For example, if a market index is composed of companies X and Y, both of which have the same P/E ratio (which causes the market index to have the same ratio as well) but X has a 9 times greater market cap than Y, then a percentage drop in earnings per share in Y should yield a much smaller effect in the market index than the same percentage drop in earnings per share in X. One easy way of looking up a market index P/E ratio is to look up the P/E ratio of an
exchange-traded fundAn exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
that tracks the index. For example
SPY tracks the S&P 500 Index, while
VTI tracks the
Wilshire 5000The Wilshire 5000 Total Market Index, or more simply the Wilshire 5000, is a market-capitalization-weighted index of the market value of all stocks actively traded in the United States. Currently, the index contains over 4,100 components...
index.
A variation that is often used is to exclude companies with negative earnings from the sample - especially when looking at sub-indices with a lower number of stocks where companies with negative earnings will distort the figures.
In Stocks for the Long Run, Jeremy Siegel argues that the earnings yield is a good indicator of the market performance on the long run. The average P/E for the past 130 years has been 12.1 (i.e. earnings yield 8.3 percent).
Accuracy and context
In practice, decisions must be made as to how to exactly specify the inputs used in the calculations.
- Does the current market price accurately value the organization?
- How is income to be calculated and for what periods? How do we calculate total capitalization?
- Can these values be trusted?
- What are the revenue and earnings growth prospects over the time frame one is investing in?
- Were there special one-time charges which artificially lowered (or artificially raised) the earnings used in the calculation, and did those charges cause a drop in stock price or were they ignored?
- Were these charges truly one-time, or is the company trying to manipulate us into thinking so?
- What kind of P/E ratios is the market giving to similar companies, and also the P/E ratio of the entire market?
- Are P/E ratios an accurate measure?
Historical vs. Projected Earnings
A distinction has to be made between the
fundamental (or intrinsic) P/E and the way we actually compute P/Es. The fundamental or intrinsic P/E examines earnings forecasts. That is what was done in the analogy above. In reality, we actually compute P/Es using the latest 12 month corporate earnings. Using past earnings introduces a temporal mismatch, but it is felt that having this mismatch is better than using future earnings, since future earnings estimates are notoriously inaccurate and susceptible to deliberate manipulation.
On the other hand, just because a stock is trading at a low fundamental P/E is not an indicator that the stock is undervalued. A stock may be trading at a low P/E because the investors are less optimistic about the future earnings from the stock. Thus, one way to get a fair comparison between stocks is to use their
primary P/E. This primary P/E is based on the earnings projections made for the next years to which a discount calculation is applied.
The P/E ratio in business culture
The P/E ratio of a company is a significant focus for management in many companies and industries. This is because management is primarily paid with their company's stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders), in order to increase the stock price. The stock price can increase in one of two ways: either through improved earnings or through an improved multiple that the market assigns to those earnings. As mentioned earlier, a higher P/E ratio is the result of a sustainable advantage that allows a company to grow earnings over time (i.e., investors are paying for their peace of mind). Efforts by management to convince investors that their companies do have a sustainable advantage have had profound effects on business:
- The primary motivation for building conglomerates
A conglomerate is a combination of two or more corporations engaged in entirely different businesses that fall under one corporate structure , usually involving a parent company and several subsidiaries. Often, a conglomerate is a multi-industry company...
is to diversify earnings so that they go up steadily over time.
- The choice of businesses which are enhanced or closed down or sold within these conglomerates is often made based on their perceived volatility, regardless of the absolute level of profits or profit margins.
- One of the main genres of financial fraud, "slush fund
A slush fund, colloquially, is an auxiliary monetary account or a reserve fund. However, in the context of corrupt dealings, such as those by governments or large corporations, a slush fund can have particular connotations of illegality, illegitimacy, or secrecy in regard to the use of this money...
accounting" (hiding excess earnings in good years to cover for losses in lean years), is designed to create the image that the company always slowly but steadily increases profits, with the goal to increase the P/E ratio.
These and many other actions used by companies to structure themselves to be perceived as commanding a higher P/E ratio can seem counterintuitive to some, because while they may decrease the absolute level of profits they are designed to increase the stock price. Thus, in this situation, maximizing the stock price acts as a
perverse incentiveA perverse incentive is an incentive that has an unintended and undesirable result which is contrary to the interests of the incentive makers. Perverse incentives are a type of unintended consequences.- Examples :...
.
Recent historic values
There is no theoretically ideal P/E ratio for a company. For instance, the
Alternative Investment MarketAIM is a sub-market of the London Stock Exchange, allowing smaller companies to float shares with a more flexible regulatory system than is applicable to the main market....
in London comprises mining companies like Talvivaara with P/E ratio exceeding 99000 in late November 2008.
Here are the recent year end values of the S&P 500 index and the associated P/E as reported. For a list of recent contractions (
recessionIn economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...
s) and expansions see
US Business Cycle Expansions and Contractions.
| Date |
Index |
P/E |
EPS growth % |
Comment |
| 2009-06-30 |
919.32 |
122.41 |
-- |
|
| 2009-03-31 |
797.87 |
116.31 |
-- |
|
| 2008-12-31 |
903.25 |
60.70 |
-- |
|
| 2007-12-31 |
1468.36 |
22.19 |
1.4 |
|
| 2006-12-31 |
1418.30 |
17.40 |
14.7 |
|
| 2005-12-31 |
1248.29 |
17.85 |
13.0 |
|
| 2004-12-31 |
1211.92 |
20.70 |
23.8 |
|
| 2003-12-31 |
1111.92 |
22.81 |
18.8 |
|
| 2002-12-31 |
879.82 |
31.89 |
18.5 |
|
| 2001-12-31 |
1148.08 |
46.50 |
| 2001 contraction The early 2000s recession was a decline in economic activity which occurred mainly in developed countries. The recession affected the European Union mostly during 2000 and 2001 and the United States mostly in 2002 and 2003. The UK, Canada and Australia avoided the recession for the most part, while...
resulting in P/E Peak |
| 2000-12-31 |
1320.28 |
26.41 |
8.6 |
Dot-com bubbleThe dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
burst: March 10, 2000 |
| 1999-12-31 |
1469.25 |
30.50 |
16.7 |
|
| 1998-12-31 |
1229.23 |
32.60 |
0.6 |
|
| 1997-12-31 |
970.43 |
24.43 |
8.3 |
|
| 1996-12-31 |
740.74 |
19.13 |
7.3 |
|
| 1995-12-31 |
615.93 |
18.14 |
18.7 |
|
| 1994-12-31 |
459.27 |
15.01 |
18.0 |
Low P/E due to high recent earnings growth Earnings growth is the annual rate of growth of earnings from investments.-Overview:Generally, the greater the earnings growth, the better.When the dividend payout ratio is the same, the dividend growth rate is equal to the earnings growth rate....
. |
| 1993-12-31 |
466.45 |
21.31 |
28.9 |
|
| 1992-12-31 |
435.71 |
22.82 |
8.1 |
|
| 1991-12-31 |
417.09 |
26.12 |
|
| 1990-12-31 |
330.22 |
15.47 |
| July 1990-March 1991 contraction. |
| 1989-12-31 |
353.40 |
15.45 |
. |
|
| 1988-12-31 |
277.72 |
11.69 |
. |
Bottom (Black Monday In finance, Black Monday refers to Monday October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. The crash began in Hong Kong and spread west to Europe, hitting the United States after other markets had already declined by a significant margin...
was Oct 19, 1987) |
Note that at the height of the
Dot-com bubbleThe dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
P/E had risen to 32. The collapse in earnings caused P/E to rise to 46.50 in 2001. It has declined to a more sustainable region of 17. Its decline in recent years has been due to higher
earnings growthEarnings growth is the annual rate of growth of earnings from investments.-Overview:Generally, the greater the earnings growth, the better.When the dividend payout ratio is the same, the dividend growth rate is equal to the earnings growth rate....
.
During 1920-1990, the P/E ratio was mostly between 10 and 20, except for some brief periods. Jeremy Siegel has suggested that the average P/E ratio of about 15 (or earnings yield of about 6.6%) arises due to the long term returns for stocks of about 6.8%.
Jeremy Siegel in
Stocks for the Long RunStocks for the Long Run is a book on investing by Jeremy Siegel. Its first edition was released in 1994. Its fourth edition was released on November 27, 2007...
, (2002 edition) had argued that with the favorable developments like the lower capital gains tax rates and transaction costs, P/E ratio in "low twenties" is sustainable, although higher than the historic average.
See also
- Dividend yield
The dividend yield or the dividend-price ratio on a company stock is the company's total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage...
- Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
- List of finance topics
- Stock market
A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...
- Stock market bubble
A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation....
- Stock market crash
A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors...
- Stock valuation
In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally potential market prices, and thus to profit from price movement – stocks that are judged...
- Value investing
Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
External links