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Price/Earnings Ratio (P/E): Definition, Calculation, Interpretation

The P/E ratio is a stock market indicator that allows to determine if a share is expensive compared to others. The higher it is, the more likely the stock appears to be overpriced. The P/E ratio, roughly speaking, corresponds to the number of years it would take at constant growth to fully repay the amount of the investment through dividends. Thus, it is the opposite of a stock's yield rate.

Reading Time : 5 minut(s) - | Published on 22-06-2023 13:43 

A measure to assess a company

When purchasing a stock, an investor's main task is to determine if its price accurately reflects the company's value. Because in the stock market, stock prices are determined by the intersection of supply and demand. The more buyers for the stock, the higher the price rises. Conversely, the less buyers there are compared to sellers, the lower the price drops.

Therefore, a stock's price never matches the actual value of the company: it can be higher or lower. Sometimes it may even be completely disconnected. The market value of some airlines, for example, ended up significantly lower than the total value of their fleet of planes in 2008, during the financial crisis. This undervaluation led some investors to bet on a strong rebound in the shares.

By estimating the gap between the stock prices and the target company's value, it is possible to form an opinion about the investment's worth. Who would want to buy a stock that is overpriced by double, or conversely, who wouldn't examine more closely the opportunity of an undervalued title?

This is the theory, because in practice the difficulty hides in the essential: evaluating the company. What value are we talking about? Is it the value of all the assets it owns, a multiple of the profit it will potentially distribute in the future, or a mix of all this?

The task is complex: there are a multitude of approaches for assessing the opportunity of an investment. The EBITDA approach, which highlights gross profit, is one. The approach by the ratio of profit to stock price, the "price/earnings ratio" (or P/E, PER, sometimes called p/e/a/r) is another.

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Approaching profitability through the P/E/R

If you visit a stock trading platform, you will notice that the "P/E" or Price/Earnings ratio is one of the financial indicators mentioned for stocks, alongside EPS (earnings per share) and PEG (Price-Earnings to Growth, which is the P/E ratio adjusted to the estimated growth rate of future results).

From the English term "Price/Earnings Ratio", the P/E ratio is useful for finding the best investment opportunities when composing a stock portfolio. It is one of the most commonly used tools by investors.

The P/E ratio is a financial analysis indicator. Therefore, it is frequently encountered in the stock market, where it is used to determine the value of a stock compared to other stocks in the same sector. Although it only indirectly takes into account the economic structure of the company (debt, cash, dividend yield, etc.), it is a basic element in the calculation of several other financial indicators.

The price/earnings ratio helps to estimate the intrinsic value of a company based on its dividend distribution. It determines whether the market price of a stock is disconnected from the value assigned to it by the market. It also aids in comparing the valuation of the same company over time.

The P/E ratio is also a way to approach the yield of a share and its comparative value to risk-free investments. Investing in stocks carries a risk of losing all or part of the invested capital. To take this risk, investors demand a "premium", symbolized by the gap between the rate of return on the stock and that of government bonds, which are considered risk-free.

Moreover, the value of the P/E ratio can be influenced by the property rights of investors and valuation levels. Since it depends mainly on the industry in which the analyzed company operates, this indicator also serves to compare the valuation of several companies within the same sector.

How is the P/E ratio calculated

The P/E ratio, or "Price-to-Earnings ratio," can be calculated in two ways.

Either by dividing a company's market capitalization by its net income at the end of the fiscal year, or by dividing the share price by the net earnings per share (EPS). This net income is determined by dividing the company's earnings by the number of ordinary shares in circulation. Thus:

- P/E ratio = Market capitalization / Net income
- P/E ratio = Share price / Net earnings per share

To get a fair value of the P/E ratio, it's important to use data from the company's latest annual fiscal year. However, the most experienced financial analysts may use quarterly data to determine a trailing P/E ratio.

They also have the option to use forecasted earnings data to assess a future P/E ratio. In fact, these anticipations are most often noted on the stock sheets on stock trading platforms. These calculations provide an insight into possible progressions of the share. This is interesting data for a medium or long-term view.

The P/E ratio also corresponds to the inverse of the yield rate. Thus:

- Yield rate of the share = 1 / P/E ratio of the share
Yield indeed corresponds to the amount of the dividend divided by the share price. Knowing the yield can also be enlightening in measuring the relevance in comparison to risk-free investments.

How to understand a P/E ratio

Also referred to as a company's "capitalization multiple," the price-earnings ratio informs what investors are willing to pay for a share based on its earnings. A low P/E ratio indicates a cheap (affordable) stock, while a high P/E ratio usually indicates an expensive stock compared to other companies, either because it is overvalued, or because investors have high expectations for future profits.

Conversely, a low price-earnings ratio characterizes a stock that generates less interest and is sometimes undervalued compared to fundamentals. Companies with a small P/E ratio are therefore often less volatile. They have less significant prospects, but generally offer more stability (this remains a trend and cannot be a certainty for individual stocks).

Generally, the value of the price-earnings ratio helps identify the expectations of financial markets regarding a company's profit and profitability prospects. This makes perfect sense since one of its components is the stock price. It justifies, for example, the fact that listed companies that are likely to be subject to a public tender offer see their P/E ratio increase in case of stock gathering and anticipation of control shift.

P/E/A/R: example of interpretation

Let's take the example of L'Oreal. In 2022, its net earnings per share were 10.65 euros. Its end-of-year share price was 356.15 euros. Therefore, its P/E ratio was 381.8/10.65 = 35.85. In other words, the share price was 33.44 times its profit. At a constant rate, it would have taken about 33 years to completely pay back the initial investment amount through dividends. Its yield (excluding valuation) was 1 / 33, or 3.03%. This is low, since the rate of OATs, reputedly risk-free state loans, was then at 3%.

In the same sector, Interparfums reported a net income per share of 1.61 euros in 2022. Its year-end share price was 71.50 euros. Hence, its P/E/A/R 2022 was 71.50/1.61 = 44.41. The share price, therefore, equated to 44.41 times the company's earnings. Therefore, it would have taken 44.4 years to pay off the amount of the investment, at a constant ratio. The yield here was 1/44.4, or 2.25%. This is lower than the OATs.

The P/E ratio thus allows for determining that these 2 shares were pricey in comparison to their profit potential, compared to the interest rates for risk-free investments. However, this analysis alone is not sufficient to make an investment decision. Other ratios, economic and sector analysis, as well as company outlooks should be studied (patents and innovations, whether or not established in new markets, legal environment...).

What is the importance of the P/E ratio in the context of an investment

The Price-Earning ratio provides the opportunity to compare stocks. Its determination also allows finding out whether a stock is undervalued or overvalued compared to its reference market. The P/E ratio is a useful starting point to effectively filter the number of investment options available.

This indicator is also handy for focusing investment offer research on specific companies in a sector. It's thus possible to establish an investment strategy based solely on the price-earnings ratio.

For greater effectiveness in the approach, however, it's advisable to analyze other indicators apart from the P/E to reduce the risks of poor anticipations. And remember that investing in stocks can't be guaranteed and suggests the possibility of losing all or part of one's capital. It's better to invest wisely and diversify.

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