Price-to-earnings (P/E) ratio

Key takeaways

• P/E equals share price divided by earnings per share, or equivalently equity value divided by net income attributable to common shareholders.
• Trailing P/E uses the last twelve months of earnings, forward P/E uses expected earnings, normalized P/E strips out one-off items and the Shiller CAPE uses ten years of inflation-adjusted earnings.
• The Gordon growth model gives a justified P/E: trailing P/E = payout x (1 + g) / (r - g), and forward P/E = payout / (r - g).
• A higher P/E is justified by faster sustainable growth, a higher payout for the same growth, or a lower cost of equity; it is not by itself a sign of overvaluation.
• Leverage and debt-funded buybacks can raise EPS and lower P/E without making the business more valuable, which is why EV multiples are used to compare operations.
• P/E is not meaningful for loss-making companies; the earnings yield (the inverse) remains usable and averages more sensibly.

Two ways to calculate P/E

The ratio can be computed per share or in aggregate, and the two must give the same answer. Per share, divide the share price by earnings per share (EPS). In aggregate, divide equity value (market capitalization) by net income attributable to common shareholders. Both use the equity claim in the numerator and a post-interest, post-tax, post-preferred-dividend profit in the denominator, which satisfies the consistency rule.

The aggregate version is useful when valuing a private company, which has no share price, and when the share count changed during the year, because per-share EPS uses a weighted average share count while market capitalization uses the current count. For a listed company with a stable share count, the two are interchangeable.

Use diluted figures on both sides. Diluted EPS already reflects options and convertibles, so it pairs with a price that is applied to fully diluted shares. Dividing a price by basic EPS, or a diluted equity value by basic net income per share, mixes two share counts.

Net income here means profit attributable to common shareholders of the parent: after the non-controlling interest share of subsidiary profits, and after preferred dividends. Reported headline net income sometimes includes both, so check the line.

Trailing, forward, normalized and CAPE

Trailing P/E, also called LTM (last twelve months) or TTM (trailing twelve months) P/E, uses reported earnings for the most recent four quarters. Its strength is that the earnings are real and audited or reviewed. Its weakness is that price reflects the future while the earnings reflect the past, so a company whose profits are about to grow quickly looks expensive on trailing P/E.

Forward P/E uses expected EPS for the next twelve months (NTM) or the next fiscal year, usually taken from consensus analyst estimates or from the analyst's own model. It matches the forward-looking nature of price, but the earnings are forecasts and may be wrong, and consensus estimates tend to be revised as the year unfolds.

Normalized P/E adjusts earnings to a sustainable level. One version strips out non-recurring items such as restructuring charges, impairments, litigation settlements and gains on asset sales, always on an after-tax basis. Another version, used for cyclical businesses, estimates mid-cycle earnings, because a steel producer or a homebuilder at peak profits will show a low P/E exactly when its earnings are least sustainable.

The cyclically adjusted P/E, or CAPE, popularized by economist Robert Shiller and often called the Shiller P/E, divides price by the average of ten years of inflation-adjusted earnings. It is mostly applied to whole equity markets or indices rather than individual companies, as a way to look through the business cycle. Because it averages real earnings, it responds slowly to structural change such as a shift in accounting rules or in the mix of sectors in an index.

What a P/E ratio implies: the justified P/E

A multiple is shorthand for a valuation model. The cleanest link comes from the Gordon growth model, which values a share as the next dividend divided by the difference between the cost of equity and a constant long-run growth rate. Dividing both sides by earnings turns a dividend valuation into a P/E.

Start with the model: P0 = D1 / (r - g). The next dividend equals next year's earnings times the payout ratio, D1 = E1 x payout. Divide by E1 and you have the forward justified P/E. Next year's earnings equal this year's grown by g, E1 = E0 x (1 + g), so dividing by E0 instead gives the trailing justified P/E.

The formula shows the three drivers of a P/E. The multiple rises with the payout ratio, rises with growth and falls with the cost of equity. It also shows why growth and payout cannot be chosen freely. A company can only grow its earnings by reinvesting, so the sustainable growth rate is the retention ratio (one minus payout) times return on equity. Raising the payout while holding growth constant is only possible if returns on the retained capital rise.

The model assumes constant growth forever and requires r to be greater than g. It is least reliable for young, fast-growing companies and most useful for mature businesses and as a way to reverse-engineer what a market price assumes.

How leverage and buybacks distort P/E

Because P/E sits on the equity side, anything that changes the financing of a company changes its P/E even if the operations are untouched. Adding debt raises interest expense and reduces net income, but it also reduces the equity value that remains. Whether P/E rises or falls depends on the relationship between the cost of the debt and the earnings yield.

Share buybacks work through the same arithmetic. A buyback reduces the share count, which raises EPS. If it is funded from cash, EPS also loses the interest income on that cash; if it is funded with new debt, EPS loses the after-tax interest cost. The rule of thumb that follows: a buyback increases EPS whenever the earnings yield on the shares bought exceeds the after-tax cost of the money used to buy them.

An EPS increase from a buyback is not the same as value creation. The company has swapped equity for debt at market prices. The enterprise value is unchanged, the shareholders who remain own a more leveraged claim, and that claim is riskier, which in theory raises the cost of equity and pulls the justified P/E down. A falling P/E after a debt-funded buyback is the market pricing that extra risk, not a sign that the shares became cheap.

Negative and near-zero earnings

When EPS is negative, the P/E is negative and has no economic meaning. A price of $25 on a loss of $1.00 per share does not mean the shares are priced at minus 25 times earnings in any useful sense. Data providers show such cases as NM (not meaningful) and exclude them from averages.

Near-zero earnings create the opposite problem. A company earning $0.10 per share at a price of $30 has a P/E of 300x, which will dominate any simple average of a peer group. Excluding it hides information; including it distorts the average.

The earnings yield handles both cases. It moves smoothly through zero, remains ranked in the right order (a lower yield means a more expensive stock), and can be averaged. The average of earnings yields, inverted, is the harmonic mean of the P/E ratios, which is the statistically correct way to average a ratio with price in the numerator. For loss-making companies, analysts also switch to measures higher up the income statement, such as EV/Sales or EV/gross profit, or value them on forecast earnings several years out and discount back.

A worked valuation: Pembury Foods

Pembury Foods is a hypothetical listed packaged food company. The example below computes its trailing, normalized and forward P/E, then asks two questions a practitioner would ask: what growth does the current price imply, and what is the share worth on the analyst's own growth view?

Pembury's reported net income includes a one-off gain on the sale of a warehouse. The normalized figure removes the gain after tax. The forward figure is the analyst's forecast. Pembury pays out half its earnings as dividends and the analyst estimates its cost of equity at 9 percent.

Using P/E well

P/E is most useful for mature, profitable companies with stable capital structures and similar accounting, such as consumer staples, established industrials and many financial companies. It is least useful for loss-making companies, highly cyclical companies at the top or bottom of their cycle, and companies with large non-cash charges such as amortization of acquired intangibles, where reported earnings understate cash generation.

Private equity investors rarely price a buyout on P/E, because the buyer will replace the capital structure and the target's current net income reflects financing that will not survive the deal. They use it instead as a cross-check against public comparables and as the language of exit to public markets, where an IPO is often marketed on a forward P/E.

Whatever the use, state the variant (trailing, forward, normalized), the share count (diluted), and the adjustments made to earnings. Two P/E ratios are comparable only when all three match.