How to interpret the P/E ratio

The Price to Earnings (P/E) ratio is one of the many investment metrics Sharesight displays on stocks to help investors make better investing decisions. Investors and analysts alike often use this metric to determine whether a stock’s price is of fair value. To learn more about the different types of P/E ratios and how to interpret them as an investor, keep reading.

What is the P/E ratio?

The P/E ratio is a widely used measure of stock valuation and is generally based on the most recent price divided by the earnings per share (EPS) of a company. Investors can use the P/E ratio to assess a stock’s relative value against the current market price, which allows them to find opportunities to trade when these values diverge significantly.

How to interpret different types of P/E ratios

The P/E ratio can hide a number of subtleties, which are important to understand if you are going to make use of this ratio.

1. Unadjusted historical P/E

This is the P/E ratio figure the ASX produces and is displayed in Sharesight for stocks listed on this particular exchange. It is the most basic version and takes the reported EPS of the last two 6-month reporting periods and is divided into the current price. It is generally sufficient, but the limitation is that it is backward looking and doesn’t adjust for one-off "abnormal earnings" which might skew the results up or down for one particular year.

2. Forward P/E

This is what most research analysts will show in their reports. This takes the forecast current year earnings (as predicted by the analyst) and is divided into the current price. This has the benefit of being forward looking, which is more important to the stock price. It will also usually adjust for abnormals. However, it has the downside that it is based on a prediction which can be (and frequently is) wrong. It’s not easy to predict the future!

3. Time-weighted adjusted P/E

This is a variation of the two which Morningstar still uses and which I quite like (I was a co-developer of it). It takes the average of consensus forecasts and the last actual and weighs it by the time elapsed from the last actual to the next year end. It also adjusts for abnormals. It tends to produce more balanced P/Es which are easier to compare with each other and less subject to short-term swings.

In short – understand what you’re looking at when interpreting P/E ratio data.

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Disclaimer: The above article is for informational purposes only and does not constitute a product recommendation, or taxation or financial advice and should not be relied upon as such. Always check with your financial adviser or accountant to obtain the correct advice for your situation.

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