Definition
The financial metric known as the price to earnings ratio, or P/E ratio, tells the analyst or investor the cost to acquire $1.00 of the company's earnings. The price to earnings ratio only requires two inputs: the current market price of common stock and the company's earnings per share.
Calculation
Price to Earnings = Market Value per Share / Annual Earnings per Share
Where:
Annual Earnings per Share = Net Income / Shares of Common Stock Outstanding
Explanation
First made popular by Benjamin Graham, the price to earnings ratio was deemed to be one of the quickest and most accurate ways to make value comparisons. While the convention is to report the P/E in terms of past earnings, the ratio is often reported in one of two ways:
Trailing P/E (ttm): uses the trailing twelve months (ttm) of earnings; therefore, is a historical account of this ratio.
Forward P/E: uses a forecast of earnings over the next twelve months, thereby providing a forward-looking metric.
Stocks that are expected to grow earnings in the near term are typically rewarded by investors with a price per share that results in a higher P/E ratio. Companies with lower growth prospects will usually have a lower P/E. When two companies have similar earnings growth outlooks, the company with the lower P/E is said to be undervalued by the market.
When drawing conclusions about the relative performance of a company, benchmark comparisons should be made with competitors in the same industry.
Example
Company A's current market price per share of common stock is $88.24. Company A's income statement indicates net income of $4,283,000 and the company has 693,000 shares of common stock outstanding. The price to earnings ratio of Company A would be:
= $88.24 / ($4,283,000 / 693,000) = $88.24 / $6.18, or 14.27
Since the above calculation uses the historical earnings value, the above ratio would be considered a trailing twelve months P/E (ttm).
Related Terms
income statement, net income, price to book ratio
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