What is PE Ratio?

Introduction - P/E Ratio Explained

Before you can understand PE Ratio (price to earnings ratio), you must have a fundamental understanding of stock ownership. We will break stock ownership down to simple form by forcing you to put yourself in the shoes of a local business buyer. This thought experiment will reduce the complex nature of stock ownership into a more simple, everyday math problem that even non-finance trained individuals can understand.

Why Own Stocks?

An easy way to understand stock ownership, is to imagine you are purchasing a local business. Say you are interested in buying a coffee shop downtown for $150,000 or your life savings. This is a hefty sum that you could alternatively spend on fun adventures or a sports car, so why invest in this coffee shop?

The first reason is because the coffee shop will generate income which will enhance your future consumption. If the coffee shop generates $15,000 per year, it is easy to see that after 10 years you will have generated more income than your initial investment, and this income could be assumed to continue for years to come. This is a much better proposition than if you spent the seed money evenly over the next 10 years.

The second reason is because the coffee shop could be worth much more in the near future which allows you to sell it and generate a profit. In other words, your investment could appreciate. Say the coffee shop you purchased is in a downtown area that is experiencing government funds for revitalization. If this revitalization is successful, your coffee shop could be in high demand by other investors. In three years, another investor could offer you $200,000 for your business which would add $50,000 to your wealth.

Both reasons are valid and crucial considerations for investors. While many seasoned investors will declare that PE Ratio is only concerned with a stock’s ability to generate income, we will learn that comparing PE Ratios can say a lot about investors’ expectations and growth assumptions. Expectations that seem far-fetched may present opportunity.

Defining and Calculating P/E Ratio

PE Ratio is defined as the price of an investment divided by the income that the investment earns. Income is not solely dividends paid as it includes the entire net income. Income can also be forward looking or trailing. Forward looking income is based on expectations and growth assumptions for the next year whereas trailing is based on actual earnings in the prior year. This distinction is subtle but very important and distinctions are discussed in later articles called trailing versus forward PE Ratio. Careful when using PE Ratios to ensure you know which type you are looking at. In the examples below we utilize the prior year’s earnings, implying trailing PE Ratios.

For an example, let’s observe Apple (ticker: AAPL). Apple earned about $57B in 2020, and at the end of the year the stock traded with a market capitalization of about $2,200B. In other words, you could buy all of Apple for $2,200B which last year generated $57B in income per year. The PE Ratio calculation is as follows:

PE Ratio = $2,200B / $57B = 38.60

Let’s run through another example using Procter and Gamble (ticker: PG). In 2020, Procter and Gamble earned about $5.38 per share and at the end of the year was trading at about $140 per share. The calculation is as follows:

PE Ratio = $140 / $5.38 = 26.02

Simple, right? PE Ratio tells you how much you are paying per dollar of income. A natural question to ask is why not sell all your Apple and buy Procter and Gamble as its profit is cheaper? While this question is logical, we will learn numerous reasons why certain stocks can have persistently high or low PE ratios. On the other hand, we will also observe historical stock index data that shows a modestly negative correlation between the S&P 500 and its trailing PE Ratio. This will show that reducing your equity holdings when PE Ratio is high may be a great strategy. In other words, PE Ratio is important as a value metric.

Next Article -- Trailing versus Forward PE Ratio

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