The Price-Earnings Ratio: Understanding the Different Versions
The price-earnings ratio (P/E ratio) is a widely used metric to determine a company’s value in the stock market. It measures the price of a company’s stock relative to its earnings per share (EPS). However, there are multiple versions of the P/E ratio, depending on whether earnings are projected or realized, and the type of earnings.
The most common version of the P/E ratio is the trailing P/E ratio. It uses the weighted average share price of common shares in issue divided by the net income for the most recent 12-month period. Monthly earnings data for individual companies are not available, so the previous four quarterly earnings reports are used and earnings per share are updated quarterly. Note that each company chooses its own financial year, so the timing of updates varies from one to another. The trailing P/E ratio is the most commonly used P/E ratio if no other qualifier is specified.
Another version of the P/E ratio is the trailing P/E from continued operations. This uses operating earnings, which exclude earnings from discontinued operations, extraordinary items (e.g., one-off windfalls and write-downs), and accounting changes. This version of the P/E ratio provides a more accurate measure of a company’s ongoing earnings performance by excluding one-time events that may not be representative of the company’s overall financial health.
The forward P/E ratio is another version of the P/E ratio that uses estimated net earnings over the next 12 months instead of net income. Estimates are typically derived as the mean of those published by a select group of analysts. However, the selection criteria for these analysts are rarely cited. The forward P/E ratio is useful for investors who want to know how a company is expected to perform in the future based on current market conditions and analyst estimates.
It is essential to note that variations on the standard trailing and forward P/E ratios are common. Alternative P/E measures substitute different measures of earnings, such as rolling averages over longer periods of time, to attempt to “smooth” volatile or cyclical earnings, or “corrected” earnings figures that exclude certain extraordinary events or one-off gains or losses. The definitions may not be standardized, and it is crucial to understand the nuances of each measure to make informed investment decisions.
It is also important to note that some people mistakenly use the formula market capitalization/net income to calculate the P/E ratio. This formula often gives the same answer as market price/earnings per share, but if new capital has been issued, it gives the wrong answer. Market capitalization = (market price) × (current number of shares), whereas earnings per share = net income/weighted average number of shares.
For companies that are loss-making or whose earnings are expected to change dramatically, a “primary” P/E ratio can be used instead. This version of the P/E ratio is based on the earnings projections made for the next years to which a discount calculation is applied. This measure is useful for investors who want to evaluate the long-term potential of a company that is not yet profitable or has a volatile earnings history.
In conclusion, understanding the different versions of the P/E ratio is crucial for investors who want to make informed investment decisions. Each version of the P/E ratio provides a different perspective on a company’s financial health and future earnings potential. It is important to analyze each measure in the context of a company’s specific industry, financial history, and future prospects to determine whether a stock is overvalued or undervalued in the market.
