Price Earnings Ratio Law and Legal Definition
The price/earnings ratio (P/E ratio) is one of a number of measures used to assess the value of a company. The "price" component of the ratio is the stock price of the company. The "earnings" portion is the net income (income after tax) reported by the company per share. These two numbers are divided to get a ratio. For example, if a company's stock sold for $24 per share and the company reported earnings per share of $1.50, the company's P/E ratio would be 16. This is also sometimes referred to as a "multiple," in the sense that the price is, in this case, 16 times earnings. The ratio also means that investors are willing to pay $24 for $1.50 in earnings. The higher the multiple the higher investor enthusiasm for the stock is, for whatever reason. A high price paid for low earnings is, obviously, a more risky investment, but the investor has faith in the company.
The P/E ratio is often taken as a "hard" measurement because the stock price is determined by open bidding in a free market by investors assumed to be well-informed—and the earnings are taken from the company's own books as reported to the public under the requirements of the securities laws. In reality, however, the price component of the ratio only partially reflects the actual value of the company. A certain and unmeasurable portion of that price is set by investor opinion and is therefore influenced by subjective perceptions based on information, lack of it, reputation, rumor, speculation, and the like. "Highflying" stocks, for instance, may have an exaggeratedly high P/E whereas very solid stocks may be "undervalued" and thus have relatively low P/Es. During the dot-com boom the former chief of the Federal Reserve, Alan Greenspan, spoke of "irrational exuberance" in the market—one source of investor motivation. With the dotcom bust, which came early in 2000, dot-com stock tumbled—and so did P/E ratios.
For these reason it is better to view the P/E ratio as at least in part a thermometer of investor confidence and not as a thermometer measuring a company's health. At the same time, the P/E ratio can directly affect the company's well-being too. With a high P/E a company has easier access to capital. A low multiple can deprive a company of investor support—indeed can expose it to hostile takeovers if its value is not fully reflected in stock value. An example will make this clear.
A diversified, large, profitable producer of industrial machinery, components, and supplies (lubricants or abrasives, for instance) may be trading at low multiples of earnings because it is serving a wide range of industries in the "traditional" categories of manufacturing. None of its product lines are "sexy" but all are producing high margins. The complexity and diversity of the company makes it difficult for stock analysts to overview or to value, and for this reason it is ignored and rarely makes anybody's "buy" list. The company's management has accumulated a lot of cash and is attempting to spend it on new properties, in part to make the company more "exciting" and thus to lift its stock. Stockholders are restless despite high dividends because the stock is not increasing in value proportional to the company's stellar performance. The management is deeply troubled by the company's P/E of 8, sometimes dipping to 7, even 6. Then the inevitable happens. Another company, quite able to see the real value of this one, mounts a hostile take-over. The stock is underpriced, the company has a lot of cash, and the stockholders are likely to side with the attacker.
Another company, with a similarly low P/E ratio, may be quite clearly visible to the investor community. Its low stock valuation, and consequently low multiple, may be due directly to its shrinking share of the market, outdated product, and several failed acquisitions. In this case the P/E accurately reflects value, in the other case not. What is true of low ratios can also be true of high ones: management may be manipulating the news in order to inflate stock value; it may be fraudulently overstating revenues or may simply dazzle stock analysts and investors based on perceived but unsubstantiated trends. Also, often, the reason for the high ratio is fully justified—in fact the high multiple may not even accurately reflect the stock's upward potential.
Not surprisingly, the literature on this subject is filled with analysis on what P/E means and how it should be read. The careful investor and analyst will look deeply into a company's operation and not simply at the tea leaves left over at the bottom of the cup. P/E is an excellent starting point for analyzing a company—or an industry, by comparing the ratios of its major participants. More needs to be known to discover a company's true value. Most acquisitions, for example, are based on discounted cash flow analysis, discussed elsewhere in this volume.
SEE ALSO Discounted Cash Flow
Damodaran, Aswath. "This Stock Is So Cheap! The Low Price-Earnings Story." informit.com. 11 June 2004. Available from http://www.informit.com/articles/article.asp?p=170894. Retrieved on 26 April 2006.
Heintz, James A., and Robert W. Parry. College Accounting. Thomson South-Western, 2005.
Pratt, Shannon P., Robert F. Reilly, and Robert P. Schweis. Valuing a Business. Fourth Edition. McGraw-Hill, 2000.
Smith, Richard L., and Janet Kiholm Smith. Entrepreneurial Finance. John Wiley, 2000.
Warren, Carl S., Philip E. Fess, and James M. Reeve. Accounting. Thomson South-Western, 2004.