The PE ratio is calculated by dividing the stock price by the earnings per share (EPS).
Three types of PE ratio mainly include static PE ratio, trailing PE (TTM PE) ratio, and forward PE ratio.
The PE ratio is generally used to measure the valuation of companies with stable earnings.
Understanding the PE 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 (PE) ratio.
The PE 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 PE ratio indicates how much per unit of net income contributes to the market cap.
For example, on November 10, 2021, Tencent's market value was HK$46,402 billion, and its 2020 net income was HK$194.8 billion, so Tencent's PE ratio in 2020 is 46402/1948=23.8×.
Classification of PE Ratio
There are several variants of the PE ratio as they are based on different periods of net income:
Static PE ratio
The static PE ratio factors in the net income of the last full fiscal year. It's easy to calculate, but the result lags behind a bit.
Trailing PE ratio (TTM PE)
The trailing PE 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 PE ratio is the sum of the net income in this report and the same indicator in the second half of last year.
Forward PE ratio
The forward PE 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 PE ratio is based.
Application of PE Ratio
The PE 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 (PS) 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 adjusted PE 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 PE ratio of a company they calculate with the average PE ratio of listed companies within the same industry or compare it with its own historical PE ratio to decide whether the company’s valuation is reasonable.