Price-to-earnings (P/E) ratio

The price-to-earnings ratio (also called PE multiple or P/E ratio) is a financial tool that investors on financial markets use to estimate the valuation of a company.

As an example, it can be used by someone who is looking to invest in a business in a given sector but is still deciding between competitors. The P/E ratio shows what people are willing to pay for a share in a business and compares that with other companies in the sector.

Dimitri Joël Nana, Director, Portfolio Risk at BDC, explains what the P/E ratio is and how it can help investors as well as company management wanting to see how they measure up against the competition.

What is the P/E ratio?

The P/E ratio is used to assess the value given to a company by investors. “In other words, the P/E ratio determines how much you are willing to pay on financial markets to acquire a share of a company,” says Nana.

Because even if two companies have the same net income, that does not mean they are valued in the same way on financial markets. “The P/E ratio could reveal a two-to-one difference between these two companies, so you have to look at the underlying reasons before deciding where to invest,” he says.

P/E ratio formula

To calculate the P/E ratio, take the unit price of a company share on the financial markets and divide it by the earnings per share.

How to calculate the P/E ratio using a balance sheet

The balance sheet section of a company’s financial statements indicates the number of common shares it holds. This is essential information in calculating the company’s earnings per share. Other key information can be found in the income statement section of the financial statements, namely, the company’s net income and preferred share dividends.

You’ll then need to go online to the financial markets to find the company’s share unit price.

Once you have this data, you can calculate the company’s P/E ratio.

Sample calculations of P/E ratio

Company A

Share price on financial markets: $3

 

Earnings per share: 0.17

To obtain the ratio that measures earnings per common share, the company’s net profit ($20,000) was used, minus the dividends on preferred shares ($3,000), divided by the number of common shares (100,000).

P/E ratio: 17.65

Company B

Share price on financial markets: $20

 

Earnings per share: 0.67

To obtain this ratio, which measures earnings per common share, the company’s net profit was used ($20,000), less the dividends on preferred shares ($10,000), divided by the number of common shares (15,000).

P/E ratio: 29.85

Analyzing a company’s P/E ratio

Let’s say Company A, which has a unit price per share of $3, keeps the same net profit over time, i.e., $20,000. This means that each year, all other things being equal, a person who has purchased a share will make $0.17.

“It will take them 17.65 years to recoup the $3 they invested to buy a share,” says Nana. “Money will be generated in subsequent years (relative to the initial amount invested).”

Let’s now a look at Company B. Say they also maintain the same net profits over time, i.e., $20,000. That means that each year, all other things being equal, a person who purchased a share will receive $0.67.

The person who bought a share in Company B will need 29.85 years to recoup the $20 they originally invested.

“In general, a smaller P/E ratio is preferable; in this example that ratio would belong to Company A, since the person would get their initial investment back faster,” says Nana.

If two companies have the same P/E ratio, such as 0.17, but the unit price of their shares on the financial markets is different ($3 and $5), then the $3 unit price would be preferable. “Because all other things being equal, less money would have to be invested for the same return,” says Nana

But you always have to make sure you’re comparing apples to apples. “You can’t compare the P/E ratios of two companies if they’re in different industries,” says Nana.

What constitutes a good price-to-earnings ratio?

Historically, a P/E ratio between 20 and 25 is considered good. “But in reality, it also depends on the industry,” Nana says. You can get a clearer picture by analyzing the averages by industry.

However, there are some differences. For example, let’s take the automotive manufacturing sector, with Tesla and Honda. “The first company is often seen as a growth stock (a company with high future potential), while the second is seen as a value stock (a mature company),” Nana says. “So, they can’t really be compared.

Tesla’s P/E ratio is very high: share price is high, while the net income is low. “That’s due to the company reinvesting its profits to maintain growth with a lot of new projects and innovation. As a result, investors expect Tesla to experience stronger growth in the future,” says Nana.

Conversely, a value company like Honda will reinvest less and pay more dividends to shareholders. “Investors will be reluctant to accept a high P/E ratio for a mature company with low growth potential,” he adds.

Comparing companies in the same industry, but in different countries, can also be risky. “For example, production methods may be differ from one country to another, so it will be difficult to compare two companies even if they are in the same sector,” he says. “An example would be conventional oil extraction, as seen in the United States, compared to Canadian oil sands.”

Why is the P/E ratio useful when comparing two companies?

When there are two companies in the same industry with similar activities and the same growth or value type, the P/E ratio is a better indicator of the company’s value than just its share price. “The P/E ratio indicates not just the share price, but also how much capital market investors are willing to pay for every dollar of the company’s net profit,” says Nana. “If the difference between the ratios of the two companies is significant, there should be good reasons for it.”

The P/E ratio is also useful for conducting a time analysis. “You can look at each company’s growth over time by tracking that ratio as well as the ratios of its competitors,” Nana adds.

What are the limitations of the P/E ratio?

The P/E ratio’s numerator, the share price determined by financial markets, has certain limitations.

“Share price is influenced by the sentiment/perception of the financial markets,” says Nana. “For instance, if a war breaks out, the share prices of companies in the surrounding areas may fall, even if the companies are not affected.”

Another influencing factor is media coverage. “A company that’s had a lot of media has a good chance of selling its shares at a higher price on the markets than a company with equally good potential but is unknown to the public,” Nana notes.

On the other hand, an exceptional event may occur during the year that will have a negative impact on the earnings per share. “This may be an unusual year and the EPS may have been positive for the last nine years,” Nana says. “We can then decide to do an average over the past 10 years to put this particular element in context. This is known as the Shiller P/E ratio.”

The P/E ratio could also be determined with estimated earnings per share, thus projecting the company’s earnings for the next year. “So, we’re projecting into the future, but you have to make sure to properly research the company’s growth potential,” Nana says.

Another solution would be to adjust the P/E ratio for the company’s anticipated growth. This is known as the price/earnings-to-growth, or PEG ratio. “This means, that for two companies with the same P/E ratio, there is an advantage in investing in the company with the highest expected growth.”

The P/E ratio is ultimate a useful tool to calculate a company’s value, but it’s even better when you also take other ratios and elements into account in your analysis. “The debt ratio is also a consideration,” Nana says. “Just as with the return on equity (ROE) ratio, the more elements you look at, the more accurate the picture.”

Next step

Find out how to analyze your financial information, increase your business’s revenue, reduce costs and price your products or services competitively by downloading our free guide for entrepreneurs entitled Build a More Profitable Business.