What is the Price-Earnings ratio (P/E)?

Key aspects

• The P/E ratio indicates how much investors are willing to pay for each dollar of a company's earnings, serving as a quick way to assess whether an asset is overvalued or undervalued.

• There are different types of P/E ratios - such as trailing, forward, absolute, and relative - that offer various perspectives, but all require context, such as industry standards and the company's growth potential.

• The P/E ratio does not work well for cryptocurrencies because most of them do not generate profits or reports in the same way as companies. However, similar valuation methods are being tested in some areas of decentralized finance (DeFi).

Introduction

If you have ever considered buying stocks, you have likely come across the term P/E ratio. It stands for Price-Earnings ratio, a tool widely used by investors to assess whether it is worth buying a stock. But what does this ratio really mean and how is it used?

What is the P/E ratio?

The P/E ratio compares a company's stock price to its earnings. It helps investors determine whether a company's stock is overvalued, undervalued, or fairly priced by comparing the current stock price to the earnings per share (EPS).

In other words, the ratio shows how much investors are willing to pay for each dollar of profit of a company.

P/E Ratio Formula

P/E Ratio = (Share Price / Earnings Per Share)

We can calculate the earnings per share (EPS) by dividing the company's total profit (after taxes and preferred dividends) by the weighted average of common shares available in the market during a specific period.

Types of P/E Ratios

There is more than one way to analyze the P/E ratio. Each version offers a different perspective:

• P/E trailing: based on the company's earnings over the last 12 months. It is the most common type and reflects actual performance.

• Forward P/E: uses profit projections for the next 12 months. It is based on expectations and estimates from analysts.

• Absolute P/E: it is simply the basic formula of the P/E ratio - the current price of the stock divided by the most recent earnings per share (EPS) - without any other reference.

• Relative P/E: compares a company's P/E ratio with a benchmark, such as the industry average or historical performance.

Interpreting the P/E ratio

To interpret the P/E ratio, it is necessary to consider the context. A high P/E ratio may suggest that investors expect high earnings growth in the future and are willing to pay a higher value for it. On the other hand, a low P/E ratio may indicate that the stock is undervalued or that the company is experiencing difficulties.

However, a "high" or "low" P/E ratio can vary depending on the sector or industry. For example, technology companies generally have higher P/E ratios compared to utility companies due to their growth potential.

Why the P/E ratio is important

The P/E ratio is a quick way for investors to evaluate the value of a stock. It is especially useful for comparing companies within the same sector. For example, if two companies operate in the same area, but one has a much higher P/E ratio, investors can analyze whether that difference is justified by higher growth expectations or other factors.

The P/E ratio is also useful for:

• Screening: investors can use the P/E ratio to identify potentially undervalued stocks.

• Evaluation of historical trends: comparing a company's current P/E ratio with its previous values can indicate how the market's perception of that company has changed over time.

• Benchmarking: comparing the P/E ratio with the industry average or the market as a whole helps to understand the context and whether the stock is fairly priced.

Limitations of the P/E ratio

Although the P/E ratio is useful, it is not perfect and should not be used in isolation. There are some limitations to consider:

• It does not work if the earnings are negative. The P/E ratio does not apply when a company is incurring losses.

• Does not reveal differences in growth rates. A higher P/E ratio may be normal for fast-growing companies, while a lower one may be expected for an older company with stable earnings. Context is important.

• It can be manipulated. Some companies may change the way they report profits to appear more positive.

• Ignore other factors. The P/E ratio does not take into account debts, cash flow, and other essential factors.

Therefore, although it is a useful tool, it is essential to also analyze other indicators, such as revenue, profit margins, and the level of the company's debt.

Comparing P/E ratios across industries

P/E ratios can vary significantly depending on the type of company. Therefore, it is important to compare companies within the same sector. For example:

• Technology sector: they generally have higher P/E ratios due to the expectation of rapid growth.

• Public utility sector: they usually have lower P/E ratios, as they have stable and predictable earnings.

If you compare the P/E ratio of a technology company with that of a utility company without considering the context, you can draw incorrect conclusions.

P/E Ratios and Cryptocurrencies

You might be wondering if the P/E ratio works for Bitcoin or other cryptocurrencies. The short answer is: not exactly. The P/E ratio is used for companies that have clear profit reports, as the calculation depends on those earnings. Most cryptocurrencies do not generate profit reports in the same way that traditional companies do.

However, some analysts use similar concepts in certain areas of the crypto sector, such as decentralized finance platforms (DeFi) that earn from fees. For example, they might evaluate the price of a cryptocurrency considering how much the platform generates from those fees. These approaches are still experimental and not widely adopted, but they indicate how people are trying to adapt traditional financial concepts to the world of cryptocurrencies.

Final considerations

The Price/Earnings ratio (P/E) is a widely used metric that gives an idea of a stock's value, comparing its current price with the company's earnings. It helps investors identify whether a stock is fairly valued based on its earnings potential. The P/E ratio is not perfect - and should not be used in isolation - but it is an excellent starting point for evaluating stocks.