The P/E Ratio

During yesterday’s Video Tutorial on How To Read a Stock Quote, one of the items pointed out was the P/E Ratio. I purposely skipped over giving an explanation as it would’ve taken the 10 minute tutorial to about 20 minutes! However, today I will follow up on that promise to explain it in more detail.

The P/E Ratio, also known as…

The P/E Ratio is such a widely used ratio that it has many different slang terms such as:

1. The Multiple
2. The Price to Earnings Ratio
3. The P/E Ratio
4. Earnings Ratio
5. Price Multiple

…and there are probably some others that aren’t top of mind right now, too.

Okay, so what is it?

The price to earnings ratio is a number that is derived from the formula:

P/E Ratio = Price Per Share / Earnings Per Share

So the “P” stands for the Price of the share, and the “E” stands for the Earnings Per Share (or ‘EPS’). If you had a stock that was trading at $50 per share on the market, and that stock had an EPS (earning per share) of $2.50, then according to this very simple formula, the P/E Ratio of this stock is 20.

But seriously Preet, what IS it?

There are a number of differet ways to look at it, but I will give you the one that makes the most sense to me. It is the price you are willing to pay today for $1 of annual income in perpetuity. So for example, for our sample stock above with a P/E of 20, that means you are willing to pay $20 today for an annual income stream of $1 for life. (It might be better to say that the market as a whole is willing to pay $20 today for that $1 annual income for life.)

I’m going to borrow an example I read elsewhere, but if a stranger came up to you and asked you to buy a $1 dollar income stream from them for life, you would have no idea if they were able to keep this promise and you might only offer them $1 simply because you don’t know or trust this person, but you think that you should be able to at least get your $1 back next year. But what if Bill Gates came up to you and offered to sell you $1 per year for life for $20? You might take him up at that price because you know that he will probably be making a lot of money for many years to come. Well, in essence Bill has a P/E ratio of 20 and the stranger has a P/E of 1.

Your expectation of Bill Gates earning lots of money in the future is solid and hence you are willing to basically wait 20 years to get your money back, at which point the future $1 annual income is gravy. (Clearly I’m not factoring in opportunity costs or interest for this example – but I will in a follow up post that is a bit more technical.)

Let’s now relate it back to the stock market

A high P/E ratio means that investors believe the future earnings of a company are expected to be strong. The stronger the earnings outlook, the more confidence people have in buying stock in the company because they believe there is a greater chance that the earnings will continue.

If someone offers to pay a higher price for a stock, they are offering to purchase the stock at a higher P/E ratio – which means they are more confident about the future of that company.

But there’s more…

When a P/E ratio really starts to get high this is due to investors not only believing the earnings are solid, but that they will probably GROW over time as well. This means that they are basically saying to themselves that they believe the $1 annual income stream will increase. Next year it might be $1.05, the year after it might be $1.12 and so on. Since they believe the earnings will grow (because the company is going to take off), they are willing to offer an even higher ‘multiple’. For example, RIM has a P/E of over 60 right now. If you only assume that you are buying $1 of annual earnings per year for $60 today, that might seem a bit crazy. But if you think that RIM will continue to increase it’s earning VERY rapidly, then you are not expecting $1 per year, but rather a very quickly increasing earnings stream.

I’ll end this primer here, but will continue in more detail with two follow up articles. One will explain in more detail how the increasing earnings expectation will affect the price someone is willing to pay for a share (and hence the very high P/E ratio), and the second will explain how to interpret the P/E when evaulating a stock and gauging the market sentiment overall in a more common manner.