Stock Valuation: The P/E Ratio Approach

An approach to valuation, practiced widely by investment analysts, is the P/E ratio or earnings multiplier approach. P/E or Price-Earnings is the ratio of a company’s share price to its per-share earnings. To calculate the P/E, the current stock price of a company needs to be divide by its earnings per share (EPS):

P/E = Market Value per share / Earnings per Share

Commonly, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E. However, occasionally the EPS figure comes from estimated earnings expected over the next four quarters. This is known as the leading or projected P/E.

A third variation that is also sometimes seen uses the EPS of the past two quarters and estimates of the next two quarters. There isn’t a huge difference between these variations. But it is important to realize that in the first calculation, the actual historical data is used. The other two calculations are based on analyst estimates that are not always perfect or precise.

Companies that are not profitable, and consequently have a negative EPS, pose a challenge when it comes to calculating their P/E. There are different outlooks on how to deal with this. Many experts say there is a negative P/E, others give a P/E of 0, while most just say the P/E doesn’t exist. Historically, the average P/E ratio in the market has been around 15-25. This fluctuates significantly depending on economic conditions. The P/E can also vary widely between different companies and industries. Therefore the factors that determine the P/E ratio are:

• The dividend payout ratio (1-b)
• The required rate of return, r
• The expected growth rate, ROE x b