What is the PE Ratio?

Key Takeaways

• The P/E ratio is calculated by dividing the stock price by the earnings per share (EPS).

• Three types of P/E ratios mainly include P/E LFY (last fiscal year) ratio, trailing P/E (TTM PE) ratio, and forward P/E ratio.

• The P/E ratio is generally used to measure the valuation of companies with stable earnings.

Understanding the P/E ratio

To determine whether a listed company is overvalued or undervalued, we need to know its relative value instead of its stock price. The most common measure of relative value is the price-to-earnings (P/E) ratio.

The P/E ratio is calculated by dividing the stock price by the earnings per share (EPS) or dividing the total market value by the net income. The P/E ratio indicates how much per unit of net income contributes to the market cap.

Classification of P/E Ratio

There are several variants of the P/E ratio as they are based on different periods of net income:

1. P/E LFY ratio

The P/E LFY (last fiscal year) ratio factors in the net income of the last full fiscal year. It's easy to calculate, but the result lags behind a bit.

2. Trailing P/E ratio (TTM P/E) 

The trailing P/E ratio is based on a company's net income over the past 12 months. For example, after a listed company announces its half-year report, the net income used for calculating the trailing P/E ratio is the sum of the net income in this report and the same indicator in the second half of last year.

3. Forward P/E ratio

The forward P/E ratio is calculated using an estimate of net income over a period of 12 months. For example, after a listed company announces a quarterly report, we can multiply the quarterly net income by 4 to get an estimated annual figure on which the forward P/E ratio is based.

Application of P/E Ratio

The P/E ratio is usually used to measure the valuation of listed companies with stable profits. For emerging companies that are not profitable or cyclical companies with unstable profits, it is more suitable to use the price-to-sales ratio (market value /revenue) or the price-to-book ratio (market value / net assets)

In addition, if investors pay more attention to the sustainable profits of listed companies, they may refer to the adjusted P/E ratio, a more accurate figure, which is based on net income subtracting one-off gains and losses such as government subsidies or investment income (losses).

Investors can compare the P/E ratio of a company they calculate with the average P/E ratio of listed companies within the same industry or compare it with its own historical P/E ratio to decide whether the company's valuation is reasonable.