» How It Can Be Used
Price-earnings ratios are most commonly used to value
Will the Real P/E
Please Stand Up?
In the world of investing, no one piece of financial in-
formation tells all.
But the price-earnings ratio comes close, containing a
wealth of information about the market’s expectations
for earnings growth.
However, if you look through any investment information
resource commonly used by individual investors, you’ll
find numerous definitions of the term.
Because the price-earnings ratio is a powerful summary of
market opinion, financial analysts have frequently fiddled
with it, producing what may appear to be endless varia-
tions on a theme.
Sorting out the different ways price-earnings ratios are
quoted and how each different price-earnings ratio tech-
nique can be applied and interpreted should aid in your
stock selection decisions.
» What It Is
Price-earnings ratios (P/Es) are determined by taking a
stock’s share price and dividing it by the firm’s earnings
per share.
The ratio simply relates share price to earnings: the higher
the price-earnings ratio, the more investors are paying for
each dollar of earnings. If a stock has a price-earnings
ratio of 15, it means that investors are paying $15 for
each $1 of earnings.
Other terms for price-earnings ratios are: earnings multiple
and price multiple.
The variations on price-earnings ratios occur with the
decisions as to what share price to use (current, average,
etc.) and which earnings figure to use (trailing 12 months,
expected earnings, etc.).
future earnings.
In general, the higher the price-earnings ratio (relative to
either its historical ratio, an industry ratio or the market
ratio) the more the market is confident that earnings will
grow in the future.
Low price-earnings ratios reflect expectations of lower
growth and greater uncertainty.
All investors should be interested in finding firms that
have a high, certain earnings growth rate and a relatively
low price-earnings ratio. However, if the market agreed
with your estimate of high growth, the price-earnings
ratio would not be relatively low; rather, it would be either
average, or perhaps even relatively high.
In order to form a judgment as to whether earnings are
overvalued, undervalued or fairly valued using P/Es, you
must judge whether you agree with the market’s opinion
regarding the firm’s growth prospects.
» How It Can Be Misused
A simple price-earnings ratio does not convey on its own
all the information you need. Instead, it needs to be judged
relative to other P/Es—by comparing a firm’s current
price-earnings ratio, for instance, to its historical P/E, the
industry average P/E or the market P/E.
Since earnings are in the denominator of the calcula-
tion, price-earnings ratios are not useful if the firm is
not generating earnings (you cannot divide by 0), or if
it has negative earnings (the resulting negative multiple
is meaningless).
One-time events may also push price-earnings ratios up
or down. Special charges or the sale of assets may lead to
reported earnings that are below or above their normal
levels. As long as the market interprets the earnings devia-
tion as being only a temporary phenomenon, the abnormal
P/E will be discounted by the market.
In addition, reported earnings themselves are subject to
many assumptions and judgments, so if you are using price-
earnings ratios, you must make sure that you understand
the quality of the underlying earnings number.
» P/E Variations
There are an endless variety of price-earnings ratio calcula-
tions. Here are the most common, along with how they
August 2007 15
 can be applied and interpreted. The median is more useful than the average because the
median, unlike the average, is not distorted by extreme
P/E Trailing Earnings values. The median of historical price-earnings ratios is
P/E trailing earnings is calculated using the most recent valuable for gauging the current price-earnings ratio versus
12 months of reported earnings. This would give the some historical norm.
most current actual earnings figure, but since earnings
are reported quarterly, the trailing earnings could be over P/E Normalized
three months old. P/E normalized is designed to derive a base, or normal,
price-earnings ratio. It is similar in purpose to the forward
P/E Current Earnings price-earnings ratio, but with the further adjustment of
P/E current earnings, used primarily by Value Line, steps using the following year’s actual earnings.
into the future while straddling the past. The earnings
used in the denominator are the most recent two quarters This approach is valuable because examining the history
of earnings plus the estimated earnings per share for the of price-earnings ratios using trailing or fiscal-year earn-
next two quarters. ings does not capture the expectational component of the
price-earnings ratio.
A common stock’s price today is based on expectations of
future performance, a forward-looking valuation. Relating A normalized price-earnings ratio goes back in time and
price to estimated earnings measures value
today relative to expectations, and can
serve as a guide as to whether a stock is P/E Definitions
relatively over- or undervalued. P/E Trailing Earnings
P/E Forward (or Estimated) Most recent market price per share divided by most recent 12
Earnings months (four quarters) of reported earnings per share.
P/E forward earnings uses estimates of
annual earnings for the fiscal year in the P/E Current Earnings
denominator. An analyst’s forecast or a
consensus of analysts is used. Most recent market price per share divided by most recent two
quarters of earnings per share plus estimated earnings per share for the
At the beginning of the year, a price- next two quarters.
earnings ratio using estimated earnings
is completely forward looking, but as P/E Forward (or Estimated) Earnings
the year-end nears, more of the estimate
Most recent market price per share divided by an analyst’s forecast
is based on actual earnings and less is a
forecast. Earnings estimates for the year or a consensus of analysts’ forecasts of earnings per share for the fiscal
are revised as new information is released year.
and quarterly earnings become available.
P/E Average Price
P/E Average Price
Average market price per share for the fiscal year divided by earnings
P/E average price divides the average
market price of the common stock for per share for the fiscal year.
the fiscal year by the earnings per share
for the fiscal year. P/E Median
Mid-value price-earnings ratio of a series of annual price-earnings
This approach attempts to smooth out ratios ranked in ascending or descending order.
the price-earnings ratio by reducing the
day-to-day variation in ratios caused by
P/E Normalized
stock price movements that may have
been the result of general volatility in A historical price-earnings ratio: the previous year-end market price
the stock market. per share divided by the following year’s actual earnings per share.

P/E Median P/E Relative

P/E median is the mid-value of a series
of annual price-earnings ratios, ranked in The firm’s price-earnings ratio divided by the market’s price-earnings
ascending or descending order. ratio. The S&P 500 is often used as a proxy for the market.

16 AAII Journal
 divides the previous year-end price, or the high or low (or
both) for the year, by the following year’s actual earnings
per share. These normalized price-earnings ratios can
then be averaged.
Rather than looking at today’s price and earnings and
determining whether the price-earnings ratio is relatively
high or low, many analysts would suggest looking at today’s
price and next year’s estimated earnings, so that the price-
earnings ratio is based on estimated earnings.
The normalized price-earnings ratio makes the adjustment
with actual, rather than estimated, earnings.
P/E Relative
P/E relative allows comparison of the price-earnings ratio
of a firm to the price-earnings ratio of the overall market,
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currently and historically.
By dividing the firm’s price-earnings ratio by the market’s
price-earnings ratio, P/E relative is determined. Often the
Standard & Poor’s 500 is used as a proxy for the market.
Prices and earnings for the firm and the market should
reflect the same period.
Looking at these figures historically would generate median
and average P/E relative figures for comparison to the
current P/E relative. The P/E relative is much like relative
strength measures, which relate the change in a stock’s
price to the change in value of a market index.
A P/E relative can also be calculated using industry
price-earnings ratio data instead of the S&P 500, if it is
available.
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