# WHAT IS A PRICE-TO-EARNINGS RATIO?

What is a P/E Ratio?

Value relativity

Price-to-Earnings (P/E) ratio is one of the many market-based valuation tools used to determine whether the stock is overvalued, undervalued or fairly valued. Various key metrics such as earnings, sales, book value or cash flow per share can be used. In this example, the earnings per share (EPS) metric will be used to demonstrate the P/E ratio application.

There are basically two types of P/E ratios: the trailing and forward P/E. The difference is the calculation of earnings per share (denominator). Trailing P/E uses the most recent 12 months earnings in the denominator while the forward P/E  utilizes the following 12 months or next fiscal year’s expected earnings.

Trailing P/E might not be useful for projections if a company’s underlying business has changed perhaps as a result of an acquisition. On the other hand, forward P/E may not be relevant if earnings trend are volatile that it would be difficult to project with any degree of accuracy.

A case in point to calculate the trailing P/E would be SIA Engineering Company (S59:SI). The firm had just reported S\$0.24 per share for fiscal year ending Mar-2014. Given the current price S\$4.90, a P/E ratio of 20.4x is calculated. To determine whether the valuation is overvalued, undervalued or fairly valued, an industry P/E ratio benchmark could be used. If SIAEC’s P/E ratio is lower than the benchmark, it could signify that the company might be undervalued. On the other hand, if the SIAEC’s P/E ratio is higher than the benchmark, it could mean that the stock is overvalued.

Value in Action

The P/E ratio is a useful way to observe the market’s optimism regarding a firm’s growth prospect. In general, it would be tough to determine whether a particular P/E is high or low without accounting for the company’s growth rate and the industry the firm is in.