The price to earnings, or P/E, ratio is a company’s stock price divided by current earnings per share, or EPS, according to the United States Private Equity Council. You get the current stock price or how much investors are currently willing to pay for a dollar of earnings when you multiply a stock’s EPS by its current price to earnings. The lower the P/E, the cheaper the stock.
Value investors often use a stock’s P/E to determine if a company is undervalued or overvalued compared to similar companies or whether the stock is a good buy at the current share price. Current earnings are critical to the equation as opposed to anticipated future earnings.
You can calculate the value of your stock using the price to earnings ratio by comparing the P/E ratio to earnings per share growth, or EPS. It can be inferred that the stock is currently undervalued if the P/E ratio sits below the EPS growth rate.
Figure Out the Current Earnings Per Share
A P/E ratio formula will calculate a company's share price or stock value, explains the Securities and Exchange Commission. The metric requires that you have the company earnings per share figure or market price that represents the most recent year or 12 months of earnings, known as a trailing P/E ratio or trailing 12-month earnings per share, or TTM. EPS is defined as a company’s net earnings less preferred dividends divided by the number of outstanding shares.
You can easily obtain a public company’s long-term EPS growth rate from a financial portal, such as Yahoo! Finance, the S&P 500 Index or MSN Money, which generally supplies numbers for the past three or five years. Calculate the current EPS growth rate by comparing the EPS for the last two or three quarters to the same quarters last year.
Compare the P/E Figures
The current P/E can be obtained from an extended quote provided by Yahoo! Finance or a similar financial website or portal. Your broker can also supply this number. You can compare the EPS growth with the current P/E when you have the two figures in hand. Therefore, it saves as a helpful benchmark.
The rule of thumb is that a fully valued stock should have a P/E that equals its earnings growth rate. The stock is undervalued if the P/E is below the EPS growth rate. It's overvalued if the P/E is above the EPS rate. It's that simple.
Drilling Down Into the P/E Numbers
Let's assume that the stock you are researching is fully valued. Its EPS growth rate equals its P/E.
- Substitute the EPS growth rate for the current P/E.
- Multiply it by the current earnings per share to arrive at the potential value of a stock.
The current EPS can also be obtained from a financial portal. The stock is undervalued if the figure is higher than the current stock price or share price. It's overvalued if the figure is lower than the current stock price.
You can also use historical P/Es instead of EPS growth rate in your calculations to see if a stock is overvalued or undervalued by historical standards. You can obtain historical P/Es from a stock data service provider, such as Value Line or MarketSmith, a service of Investor’s Business Daily.
Traps for the Unwary
Be careful with these calculations. Financial ratios and earnings ratio formulas are theoretical by their very nature and may or may not lead to profitable results when they’re applied to your investment decisions. The stock market always has a reason for setting the market value of shares the way it does.
But on the other hand, extreme market conditions and volatility, such as a sharp correction, investor panic or excessive fear, can affect average price and cause good stocks to be undervalued relative to their underlying businesses or historical averages. You might want to consider past performance and a company’s future growth prospects as well.
- Use historical P/Es instead of EPS growth rate in your calculations to see if a stock is over- or undervalued by historical standards. You can obtain historical P/Es from a stock data service provider such as Value Line or MarketSmith, a service of Investor’s Business Daily.
- Be careful: these calculations are theoretical and may or may not lead to profitable results. The market always has a reason for valuing a stock the way it does. On the other hand, extreme market conditions, such as a sharp correction, investor panic or excessive fear, can cause good stocks to be undervalued relative to their underlying businesses or historical averages.
This article was written by PocketSense staff. If you have any questions, please reach out to us on our contact us page.