Company valuation: the price/earnings ratio

The Price per Earnings ratio or P/E value gives a rough indication of how highly a share of a certain company is priced compared wot other companies. The P/E value basically tells you how much you will have to pay to own a certain share of the earnings of the company; earnings that in some companies are partly payed to the shareholders in the form of dividends.

The P/E ratio is normally defined as:

P/E = (The market value of the company) / (The total earnings of a company the last four quarters)

which is equivalent to

P/E = (Current price per share) / (The earnings per shares, EPS, of a company the last four quarters)

The earnings E of a company is normally only reported four times per year, every quarter, whereas the share price P varies by the second every day the market is open. The P/E ratio, as defined above, will therefore only be exact four times a year when the the earnings of a quarter are reported. Between the quarterly reports, the P/E value will vary depending on how the market prices the company and investors estimate the earnings in the next report to be.

Note that the number of outstanding shares in a company might vary quarter to quarter. Companies might e.g. buy their own shares to raise the share price. This is a way to give returns to investors without paying dividend that are taxable. Because the number of share in a company might vary, it might be wrong to just sum the quartely Earnings Per Shares, EPS, for the last four quarters to get the 12 month EPS value. Instead use

EPS = (Sum of the earnings after taxes for the last 12 months) / (Current number of outstanding shares)

The quarterly EPS and number of outstanding shares are reported in the quarterly earnings reports of every company. These can usually be found on the company websites. EPS can be calculated for the last 12 months or just the last quarter. The 12 month EPS, which we will need to calculate the P/E value, will, in opposite to the P/E value, not vary with the daily share price, but only be updated every time the company earnings are reported (usually four times a year).

A common opinion is that the P/E value of a reasonably priced company should be below 20. However, for companies that are expected to grow fast, higher P/E values seem to be accepted. As a tool for an investor I believe the P/E value should foremost be used as a way to compare companies with each other, rather than only stare at the absolute value. If two companies have roughly the same business model, but one have a lower P/E value, I would invest more in that one, as it makes more money per euro I invest.

In the figure below can be seen the daily P/E values for a selection of Finnish and american companies. The big jumps up and down for some companies, like Sampo and Neste, are because they reported quarterly earnings E those days that radically changed their P/E value. For an investor it might be worth looking into such jumps and understand why they have happened. It might be just temporary losses (if it is a jump up in the P/E value) or something more permanent that will not be good for the future of the company. Otherwise, the daily changes are only because of the change of the share price P . It can be seen that many companies have quite stable P/E evolutions and P/E values between 10 and 50. However, some companies with high growth expectations, like Amazon and Netflix, are well above 50. Tesla is entirely in its own category with a P/E value that has been over 1000 at times. Note that the vertical axis is logarithmic. The question for the investor is whether a company really can be worth 1000 times its earnings? or if it would be a better idea to invest more in, say, Alphabet (GOOGL), which has a much lower P/E value?

The P/E values for different companies are commonly reported on sites that report financial information about shares. One easy way is to google the share and Google will show the key information about the share and the sometimes the real time share price (See figure below).

It is worth mentioning that if a company is not making any earnings, the P/E value is in principle undefined. Sometimes negative P/E values are reported (price per losses), but how to interpret that kind of values might depend on the company. Companies without P/E values might just be doing badly, but they might also be start-up companies that are growing fast (using early investor’s money) and will hopefully start to make profit in a few years. Needless to say, companies without defined P/E values are much harder to evaluate and therefore riskier to invest in.

In summary I would consider P/E values as a rough way to compare the pricing of different shares. If two companies are quite similar in what they do but one has a higher P/E value, i.e. a higher share price compared to the company earnings, than the second one, it might indicate that the first company is overvalued and then it might make sense to invest more in the second one with a lower P/E value. Looking at the time evolution of the P/E value of a company also gives a sense how the company has been developing over the last years. If the trend goes up over the years, it might indicate overvaluation, and the opposite if the trend goes down.