Morningstar
Personal Finance

Starting out in stocks: The price-to-earnings ratio

A first step in bargain hunting.

Gareth Tingling 5 June, 2003 | 1:00PM
Facebook Twitter LinkedIn
Font-Size

The price-to-earnings ratio (P/E) is one tool used by investors to determine the relative cheapness or expensiveness of stocks. It links the market value of a company to the profits it generates. P/E ratios are calculated as the ratio of today's stock price divided by twelve-months' earnings per share. These earnings can be either recent or projected.

The ratio tells investors what price they are paying for a company's earnings. The P/E ratio is most useful as a relative tool; when one compares the P/E ratio of one company with other, similar companies. Nonetheless, it can also be evaluated on an absolute basis.

In this context, analysts generally consider P/E ratios of 10 or lower to be "cheap" and P/E ratios of 20 or higher to be expensive. This absolute value approach to the P/E ratio is based on financial theory and empirical data from years of capital markets' performance and is related to what is called the Equity Risk Premium, or the additional rate of return (over the risk-free rate) that is required by investors to compensate them for the additional risk they incur by owning equities.

The P/E ratio tells the prospective investor how many years of annual earnings it takes for a company to earn an amount equal to its market value. For example, a company with a stock price of $2 and earnings of $0.20 has a P/E ratio of 10x, and this indicates that it would take 10 years of such earnings to meet or exceed the share price. The reciprocal of this is 1/10 = 10%, which is a 10% return. Based on extrapolations of past behaviour of the S&P 500 Index, it has been shown that investors expect an 8% real return. This represents approximately a 5% risk premium over the risk-free rate, compounded annually. A P/E ratio of 10, which provides a return of 10%, is therefore generally considered to be a good price for a stock. A P/E ratio of 20 provides a rate of return of 1/20 = 5%, which is generally considered to be too low (the P/E ratio is too high) for P/E absolutists.

A barometer of change

The case for relative P/E ratios is based on an argument of P/Es as a barometer of industry or company change. P/E ratios only change if the stock price becomes decoupled from the earnings outlook. So, if P/Es are rising or falling compared to historical levels, we know that there is change in the industry or the company. The nature of that change will ultimately be expressed in the earnings outlook (as analysts revise their forecasts) and the P/E may settle back. Sometimes investors believe that analysts are either too pessimistic or are overly optimistic, and so P/E ratios remain elevated or depressed. A recent example of this phenomenon was the Internet market bubble of the late 1990s, where even with analysts' rosiest forecasts, P/E ratios for some technology companies often exceeded 60x. A P/E ratio of 60 means that at current earnings levels it would 60 years for earnings to match the market capitalization of the company, or that required rate of return was 1/60 or 1.5%. That is a huge number, and conversely, a terribly small earnings yield.

The mathematical basis for P/E ratio is something called the Dividend Discount Model, which equates price of a stock to the discounted value of its cash flows (dividends).

If we divide both sides by earnings, we get:

Looking at the components of the numerator and denominator, we can see the relationships between the P/E ratio and its component parts:
  • Growth: P/E ratios increase as the firm's growth rate increases (while the numerator increases, the denominator decreases at a faster rate);


  • Risk: P/E ratios decrease as the firm's risk increases (the required rate of return increases to reflect the higher risk premium demanded by investors);


  • Dividend payout ratio: P/E ratios may or may not increase as the dividend payout ratio increases (while the numerator increases, the denominator may increase at a faster rate if the growth rate of earnings declines because earnings that could have been invested in more profitable projects are paid out);


  • Interest rates: P/E ratios decrease as interest rates increase (and investors' required rates of return increase).

Sometimes analysts must deal with the problem of companies that lack profits. Perhaps the company is just starting up and is re-investing all of its profits, or perhaps the company is restructuring and is expected to incur a series of expenses. Regardless of the circumstances, when this occurs, there are several ways that P/E ratio can still be applied to the task of valuation. For typically profitable companies that are currently facing some adversity that erases profits, analysts might use twelve-month trailing earnings. In other cases, where the company has no history of earnings, analysts may apply industry "normal" margins to the company, making adjustments for competitive position and other factors. Yet another method involves taking the first year of expected profitability (sometimes this is many years away) and then discounting these future earnings to derive earnings for the next twelve months. Much of the use of these methods is more art than science, and analyst experience plays a crucial role in the appropriate application of the method.

A blunt instrument

Experience in the use of the P/E ratio is important because while it is relatively simple to understand and use, it is a rather blunt instrument. For detailed valuation work or in cases where a company is likely to be broken up and sold and is facing the prospect of no longer being a going concern (i.e., not operating as a business) analysts must employ other valuation methods. While a discussion of these other methods is beyond the scope of this primer, it is important to know that the P/E ratio is rarely the only valuation tool employed by analysts. Analysts use other valuation tools including the present value of discounted cash flows; enterprise value to earnings before interest, taxes, depreciation and amortization; and net asset value.

Overall, the P/E ratio is most useful as a preliminary screen for investors who wish to rank stocks on the basis of cheapness or expensiveness before performing additional research and analysis.

P/E ratios, based on recent earnings, can be found in the stock Quicktake reports on the Morningstar web sites.
No statement in this article should be construed as a recommendation to buy or sell securities or to provide investment advice or individual financial planning. Morningstar Canada does not provide specific portfolio advice and recommends the use of a qualified financial planner when appropriate.

Facebook Twitter LinkedIn
Font-Size

About Author

Gareth Tingling

Gareth Tingling  

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy       Disclosures        Accessibility

The Morningstar Star Rating for Stocks is assigned based on an analyst's estimate of a stocks fair value. It is projection/opinion and not a statement of fact. Morningstar assigns star ratings based on an analyst’s estimate of a stock's fair value. Four components drive the Star Rating: (1) our assessment of the firm’s economic moat, (2) our estimate of the stock’s fair value, (3) our uncertainty around that fair value estimate and (4) the current market price. This process culminates in a single-point star rating that is updated daily. A 5-star represents a belief that the stock is a good value at its current price; a 1-star stock isn't. If our base-case assumptions are true the market price will converge on our fair value estimate over time, generally within three years. Investments in securities are subject to market and other risks. Past performance of a security may or may not be sustained in future and is no indication of future performance. For detail information about the Morningstar Star Rating for Stocks, please visit here

Quantitative Fair Value Estimate represents Morningstar’s estimate of the per share dollar amount that a company’s equity is worth today. The Quantitative Fair Value Estimate is based on a statistical model derived from the Fair Value Estimate Morningstar’s equity analysts assign to companies which includes a financial forecast of the company. The Quantitative Fair Value Estimate is calculated daily. It is a projection/opinion and not a statement of fact. Investments in securities are subject to market and other risks. Past performance of a security may or may not be sustained in future and is no indication of future performance. For detail information about the Quantiative Fair Value Estimate, please visit here

The Morningstar Medalist Rating is the summary expression of Morningstar’s forward-looking analysis of investment strategies as offered via specific vehicles using a rating scale of Gold, Silver, Bronze, Neutral, and Negative. The Medalist Ratings indicate which investments Morningstar believes are likely to outperform a relevant index or peer group average on a risk-adjusted basis over time. Investment products are evaluated on three key pillars (People, Parent, and Process) which, when coupled with a fee assessment, forms the basis for Morningstar’s conviction in those products’ investment merits and determines the Medalist Rating they’re assigned. Pillar ratings take the form of Low, Below Average, Average, Above Average, and High. Pillars may be evaluated via an analyst’s qualitative assessment (either directly to a vehicle the analyst covers or indirectly when the pillar ratings of a covered vehicle are mapped to a related uncovered vehicle) or using algorithmic techniques. Vehicles are sorted by their expected performance into rating groups defined by their Morningstar Category and their active or passive status. When analysts directly cover a vehicle, they assign the three pillar ratings based on their qualitative assessment, subject to the oversight of the Analyst Rating Committee, and monitor and reevaluate them at least every 14 months. When the vehicles are covered either indirectly by analysts or by algorithm, the ratings are assigned monthly. For more detailed information about these ratings, including their methodology, please go to here

The Morningstar Medalist Ratings are not statements of fact, nor are they credit or risk ratings. The Morningstar Medalist Rating (i) should not be used as the sole basis in evaluating an investment product, (ii) involves unknown risks and uncertainties which may cause expectations not to occur or to differ significantly from what was expected, (iii) are not guaranteed to be based on complete or accurate assumptions or models when determined algorithmically, (iv) involve the risk that the return target will not be met due to such things as unforeseen changes in changes in management, technology, economic development, interest rate development, operating and/or material costs, competitive pressure, supervisory law, exchange rate, tax rates, exchange rate changes, and/or changes in political and social conditions, and (v) should not be considered an offer or solicitation to buy or sell the investment product. A change in the fundamental factors underlying the Morningstar Medalist Rating can mean that the rating is subsequently no longer accurate.

For information on the historical Morningstar Medalist Rating for any managed investment Morningstar covers, please contact your local Morningstar office.

For more detailed information about conflicts of interest, including EU MAR disclosures, please see the “Morningstar Medalist Rating Analyst Conflict of Interest & Other Disclosures for EMEA”here

Select Your Site Edition To make sure the site is relevant to you, we need to know if you’re an individual investor or a financial professional.