Market Terms

Price to Earnings Ratio (P/E)

What is P/E Ratio?

The P/E Ratio, or Price-to-Earnings Ratio, is a metric used in the financial market to assess the value of a stock in relation to its earnings. It indicates how many years it would take for an investor to recover their investment, considering the company's earnings.

What Does P/E Ratio Represent?

The P/E Ratio represents the relationship between the stock price and the Earnings per Share (EPS) of the company. It shows how much investors are willing to pay for each unit of the company's earnings.

As mentioned earlier, the P/E Ratio indicates how many years it would take for the company to reach its market value with its own earnings. Therefore, companies with significant growth or those perceived favorably by the market may command higher multiples (as the market expects future earnings to rise). Conversely, companies with good earnings but facing challenging times may have lower multiples.

How to Interpret the P/E Ratio Value?

A high P/E Ratio can indicate that the stock is expensive in relation to its earnings. On the other hand, a low P/E Ratio may suggest that the stock is undervalued in relation to its earnings.

Interpreting the P/E Ratio value also depends on the sector in which the company operates. Some sectors naturally have higher P/E Ratios, while others have lower ones.

It's essential to remember that the stock market prices companies based on the future, while the P/E Ratio is a number that reflects the past. Therefore, even if a company has a very low P/E Ratio, it doesn't necessarily mean it's a bargain. There might have been some problem that will affect its future earnings, causing the multiple to "normalize".

An example is Pfizer (PFE). Its P/E Ratio at the end of 2021 was 15.10, which dropped to 8.09 in the 3rd quarter of 2022 because its share price fell by over 25% between those years, and the EPS increased. By merely analyzing this ratio, it might seem like a buying opportunity had emerged. However, during the middle of 2023, the P/E Ratio increased to 9.67, despite its share price falling by an additional 15%. This occurred because in 2022, the market began to anticipate a decline in its net income due to changes in regulation and the overall economic scenario for the pharmaceutical sector, and this decline materialized in the following quarters. Therefore, the seemingly discounted P/E Ratio in 2022 was partially an illusion since it was calculated based on the previous year's earnings, which did not repeat in the following year.

How Is the P/E Ratio Calculated?

The P/E Ratio is calculated by dividing the company's price (market cap) by the company's net income. The formula is as follows:

Or, on a per-share basis using EPS:

P/E Ratio from Graham's Perspective

Benjamin Graham, considered the father of value investing, used the P/E Ratio as one of the metrics to assess whether a stock was undervalued or not. He recommended that investors seek stocks with a P/E Ratio below the market average.

According to him, this average should be 15x, representing a return on investment in 15 years. This average applies to U.S. companies, as other exchanges (like the Brazilian B3) have different averages. Nevertheless, these days we see that this average is somewhat higher even within the New York Stock Exchange (NYSE), hovering around 19x.

Graham also warned that the P/E Ratio should be analyzed in conjunction with other metrics and information about the company, such as its financial history and market position, as well as the historical average of this multiple for that company.

By setting an average as a "target" value, we can calculate the fair stock price using the Graham's Number Calculation.

Example

PFE:

Pfizer Inc. is a global pharmaceutical company known for its work in developing various vaccines and medications.

Its net income in 2022 was $31.372B, while its stock price at the end of 2022 was $49.66 per share, resulting in a market value of approximately $287.35B. Therefore, its P/E Ratio at the end of 2022 was:

Loading...Loading...

In other words, the company was trading at 9.16 times its earnings, while its historical 10-year average was 17.83. This means the company was trading 55% below its historical average.