Price / Earnings Ratio
P/E ratio (Price to Earnings ratio) is certainly one among the repetitive jargons used by equity research analysts, experts in valuation, stock brokers, fund managers, persons dealing with insurance plans (Unit-Linked), present and prospective investors and others dealing with stock markets. Here we will describe the nuts and bolts of PE ratio and its variants.
Investors who invest in stocks receive two types of returns: one is the dividend income and the other being capital appreciation/gain. But not all companies can offer a higher dividend and a higher capital gain. The market price of a company’s shares are influenced by many factors such as the growth rate of the economy, the business cycle, the industry life cycle, impact of monetary and fiscal policy measures announced by government from time to time, company’s operating results (top-line and bottom-line growth rates), company’s proposed capex, and so on. Though there are a number of yardsticks available to predict the future market price movements of a share, the regularly used tool is Price Earnings ratio.
What P/E Ratio Measures?
P/E multiple measures the number of times the share of a company is priced in the stock market compared to its earnings. P/E Ratio is defined as Market Price per Share / Earnings per Share. For example, the P/E ratio of State Bank of India (on 05-08-2010 – NSE) was 18.21 times. MPS Rs.2628.90 divided by EPS Rs.144.37. This is known as Current P/E Ratio. The P/E ratio basically tells you how much investors are willing to pay for a stock’s earning power. The higher the P/E (generally above 30), the longer it would take for investors to get their money back. A high PE indicates that investors expect the company’s earning power to go up. The higher the P/E, the more earnings growth investors anticipate. Low P/E shares, on the other hand, are generally low-growth or mature companies. They often have long records of earnings stability and regular dividends, and are usually a relatively safe investment.
Alternatively one can compute the trailing P/E Ratio for SBI by dividing the current Market price per share by its last year  EPS. The previous year  EPS of SBI was 143.68 and the current MPS of SBI is 2628.90 and the trailing PER= 2628.90/143.68=18.29 times. This is the most commonly used P/E ratio because it is based on actual earnings and hence is more accurate. But share prices are constantly in the flux while earnings remain fixed. As a result, Forward P/E is more relevant to investors when evaluating the company.
Forward P/E multiple which reveals the number of times the price of the stock is traded in the market is compared to its estimated next year EPS. If we expect a 10% increase in the earnings of SBI due to improved macro environment and possibility of better operating results, then the forward P/E is 2628.90/158.81= 16.55 times. If you compare the current P/E of SBI with that of the forward P/E, the stock looks attractive as the forward P/E is less than the current P/E due to higher growth in earnings.
Sometimes, we need to predict the P/E for a future (over and above one year) wherein we need to compute Future P/E multiple. If the EPS of SBI is expected to be Rs 300 after 5 years (2015) then the future P/E Ratio is 2628.90/300=8.76 times, a number which is much lower than the present number i.e. 18.21 times. Note that the P/E Ratio multiple comes down drastically due to the steep increase in the forecasted future EPS; the opposite holds true for a steep decline in the forecasted future EPS number. All the variants of P/E are based on the same numerator (i.e Market Price per Share-MPS) but use different denominators (i. e. EPS-Earnings Per Share-current, trailing, forward and future). As far as the MPS is concerned, one can take either the current MPS or the 6 -12 months median MPS. It is better to employ the median number rather than the current MPS as median can help us to get away from the problem of outliers to a greater extent.
Determinants of P/E Ratio:
The P/E multiple of a company is determined by many factors but the key determinants are listed as: (a) Expected Growth Rate (b) Current and Future Risk and (c) Current and Future investment needs.
Companies with a higher expected growth rate in its businesses are normally traded at a higher P/E multiple as the earnings are expected to be attractive in the future. When the estimated EPS is higher, the forward P/E is lower compared to the current P/E. When the market gets this information, the MPS goes up as the market is willing to pay a higher price for the stock. So companies with higher growth rate trades in with higher P/E Ratio. Companies perceived by the market as riskier usually trade at lower P/E Ratio. This is because the market expects the company to face fluctuations in its operating results thereby becoming riskier especially during adverse business situations. For instance companies with higher operating leverage (higher proportion of fixed costs to total costs) and higher financial leverage (higher debt/equity ratio) are perceived to be riskier by the market. Similarly, the market discounts the share price of companies which are expected to have higher operating and financial leverage number in its future operations. Apart from leverage, a business may also face risk from business risk (business prospects), country risk, liquidity risk and so on.
P/E Ratio is also affected by the reinvestment needs of a company. For example, a company with a higher reinvestment needs is perceived as riskier as it results in the company borrowing more funds leading to higher financial leverage or issuing shares in the market thereby resulting in dilution of earnings for the existing equity shareholders. Hence companies with higher reinvestment needs are normally traded at lower market prices resulting in lower P/E multiple