What is price-to-earnings ratio or multiple (P/E) ?

Also known as the P/E or multiple, this ratio is thought to be a measure of the price paid for a share in relation to the company’s annual net income or profit earned per issued common share.

A higher P/E ratio is interpreted to mean that investors are paying more for each unit of net income, so the stock is more expensive compared to a competitor’s stock trading at a lower P/E ratio.

The P/E ratio also has value assessment expressed in units of years, which can be interpreted as “number of years of earnings to pay back purchase price,” ignoring the time value of money. In other words, P/E ratio shows current investor demand for a company share. The price per share in the numerator is the market price of a single share of the stock. The earnings per share in the denominator depends on the type of P/E: defined as:  Price-to-Earnings Ratio = The Share’s Price Per Share divided by Annual Earnings Per Share. For example, if a company’s common share is trading at $15.00 and the company has net earnings per share of $1.00, then the share’s P/E/ ratio is calculated to be 15 times earnings.

The most common forms of the P/E ratio include the following:

  • one that uses the 12-month trailing earnings per share as the denominator and GAAP net earnings as the denominator and,
  • one that uses forecasted earnings per share for the future 12-months, also known as the Forward Earnings per share.
  • a third form of the P/E ratio used by investment analysts is to substitute their the share’s current share price with their Forecasted “Target” share price divided by the Earnings Per Share
  • A fourth option gaining popularity is to use the analysts’ Forecasted “Target” Price per share divided by their Forecasted or Forward Earnings Estimate
  • A fifth option that is becoming more common is to divide the analysts’ Forecasted “Target” Price per share by the analysts’ “Adjusted” Earnings per share

Originally and historically, the price-to-earnings ratio was calculated using option #1 above, as the company’s current share price divided by the company’s General Accepted Accounting Practices (GAAP) Net Earnings Per Share. Prior to 2005, multiple comparisons, as a means for share valuation, was more meaningful, as the P/E multiples were calculated utilizing the company’s current share price divided by the company’s trailing GAAP Net Income Per Share. Earnings determined by the uniform application of GAAP were consistent and comparable for each company operating in a particular industry.

Today, calculating a P/E multiple using Forecasted or Adjusted numbers are not comparable for companies operating in the same industries, as each Adjusted number calculation may use different inputs quarter to quarter, year to year, and company to company.

For example, each Canadian bank calculates and announces their earnings as Adjusted Earnings and they even state that their Adjusted Earnings are not calculated using GAAP rules, and the earnings are not comparable to previously calculated and reported Adjusted Quarterly/Annual Earnings, and they are not comparable to the Adjusted Earnings calculated at competing Canadian banks.

The use of Adjusted Earnings by investment analysts makes P/E Ratio valuations and comparisons meaningless. This is because historical comparisons against P/Es using GAAP Net Earnings would be like comparing apples to oranges. Secondly, comparing P/E multiples calculated using Adjusted net income for different reporting periods would be inaccurate as the inputs for calculating the Adjusted number can change for each reporting period.

Comparing P/E/ ratios between different industries is less meaningful to investors as each industry may operate in completely different business environments with different business models.

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