P/E

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The Price/Earnings Ratio (P/E) is a valuation ratio where a company's current share price is divided by its per-share earnings.[1]

P/E Ratio is one of the most widely watched measures of valuation for both the stock market as a whole and for individual stocks. It is sometimes referred to as the "multiple," because it shows how much investors are willing to pay per dollar of earnings. If a company is trading at a P/E of 15, an investor would be paying $15 for $1 of earnings.[1]

P/E for a public company

P/E is a valuation ratio of a company's current share price compared to its per-share earnings. The ratio is calculated as:

Market Value Per Share / Earnings Per Share (EPS)

Investopedia explains:

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

EPS is usually from the last four quarters (Trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (Projected or Forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

The price-earnings ratio is also sometimes known as "price multiple" or "earnings multiple".

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. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number. The use of (GAAP) reported earnings vs the use of (non-GAAP) operating earnings is also a common source of confusion.

P/E for a fund or an index

There are multiple ways to compute the P/E of a fund (or an index) as a composite of individual companies' earnings and market values. The following describes distinct methodologies for TTM (Trailing Twelve Months) P/Es. It is important to only compare P/E values computed with the same methodology. There is no consensus on which approach is better. [note 1]

Standard & Poor's (S&P) computes the S&P 500 TTM P/E by dividing the current index price by the sum of the TTM earnings (positive or negative) of all constituents. To have a more manageable number for the index level, the sum of the earnings is divided by a fixed scale factor called the divisor [2]. In other words, the P/E of the index is directly proportional to the aggregate market capitalization divided by the aggregate earnings. The State Street SPDR funds display TTM P/E for the indices they track (e.g. S&P), based on a weighted harmonic average computation, which is mathematically equivalent to the S&P methodology.

ETF.com follows the same methodology as Standard & Poor's for all ETFs it tracks [3].

MSCI follows the same methodology as Standard & Poor's for all indices it publishes [4]. PE information from MSCI is only available to subscribers though.

Vanguard provides a TTM P/E metric on the Web pages describing its funds, using the following methodology [5]. First, the P/E of each constituent is determined, based on price and TTM earnings. Then a weighted harmonic average of such individual P/Es is computed, associating a weight to each constituent proportional to its market value relative to the aggregate market value of the fund. Using a harmonic average presents the advantage of reducing the effect of outliers (e.g. companies with very small earnings, hence a high P/E). Companies with negative earnings were included in the computation until May 2017 (like S&P does). Starting from June 2017, Vanguard aligned its methodology with Morningstar and now excludes companies with negative earnings from the computation [6].

Morningstar performs a computation similar to Vanguard, while applying a filter to individual P/Es [7]. Negative values are eliminated (and corresponding companies not included in the aggregate market value). Then the weighted harmonic average is computed. Note that this TTM P/E metric isn't directly accessible via the Morningstar Web pages, which display a Forward P/E (based on analysts estimates) instead of a Trailing (TTM) P/E. Ycharts.com does provide the Morningstar TTM P/E metric for funds, referring to it as "Weighted Average PE Ratio".

Shiller PE10

Robert Shiller has developed a stock valuation metric known as the "PE10"; alternatively called the CAPE (Cyclically Adjusted Price Earnings) ratio. It's P/E, but with the EPS (Earnings Per Share) averaged over the prior 10 years and is adjusted for inflation.[8]

where (current CPI-U) / (CPI-U) is the CPI-U adjustment for inflation.[note 2]

Note that Prof. Shiller uses the same methodology as Standard & Poor's to compute the 'Price' and 'Earnings' components of the equation (i.e. simple aggregate).

Notes

  1. Multiple pros and cons articles are mentioned in this forum discussion: Morningstar and P/E TTM: what a wonderful world!.
  2. The formula is from Shiller's Excel file (xls) at Online Data - Robert Shiller.

See also

References

  1. 1.0 1.1 "Price/Earnings Ratio (P/E)". Fidelity Investments. https://www.fidelity.com/learning-center/trading-investing/technical-analysis/technical-indicator-guide/pe-ratio.
  2. Inside the S&P 500: PE and Earnings Per Share
  3. Why ETF Price/Earnings Ratios Lie
  4. MSCI Methodology for Calculating Fundamental Data Ratios at Index Level, May 2006
  5. Vanguard doesn't provide a methodology document. The description was obtained in an exchange with Vanguard support.
  6. Vanguard changed their way of computing PE ratios
  7. Average Price Ratios: Morningstar Methodology Paper (2005)
  8. Online Data - Robert Shiller

External links