P/E Ratio
Definition:
P/E, or price to earnings ratio, is a valuation ratio used by investors comparing a company’s current share price to its earnings per share.
Example:
Tech stocks often have high P/E ratios because they have high expected earnings growth.
More Information:
The P/E ratio is simple to calculate, using the current share price divided by a company’s earnings per share. It can be a current P/E, comparing price to the earnings reported over the last twelve months, or it can be a forward P/E, comparing price to analyst estimates of the future earnings of a company.
P/E is actually a derived proxy for a much more detailed and in-depth fundamental investment analysis, known as a discounted cash flow, that accounts for a company’s future cash flows, discounted back to present value. Using earnings per share as a proxy for cash flow, we can derive P/E equivalent to 1 over the equity cost of capital less the earnings growth rate.
This is why the higher interest rates are, the higher the cost of capital and lower P/E ratios will be. Similarly, the higher growth rate a company has, the higher the P/E ratio will be.
As an example, if I expect a 20% return on my equity investments, and I invest in a company growing earnings at 15% per year, its P/E ratio should be 1 divided by 20% less 15%, or 20x earnings. If the stock is currently trading at 25x earnings, it is overvalued and not a good investment at the current price. If it is currently trading at 15x earnings, it is undervalued and a good investment at the current price.
