Historical vs projected earnings

A distinction has to be made between the fundamental (or intrinsic) P/E and the way we actually compute P/Es. The fundamental or intrinsic P/E examines earnings forecasts. That is what was done in the analogy above. In reality, we actually compute P/Es using the latest 12 month corporate earnings. Using past earnings introduces a temporal mismatch, but it is felt that having this mismatch is better than using future earnings, since future earnings estimates are notoriously inaccurate and susceptible to deliberate manipulation.

On the other hand, merely because a stock is trading at a low fundamental P/E is not an indicator that the stock is undervalued. A stock may be trading at a low P/E because the investors are less optimistic about the future earnings from the stock. Thus, one way to get a fair comparison between stocks is to use their primary P/E. This primary P/E is based on the earnings projections made for the next years to which a discount calculation is applied.

Dividend Yield

Publicly traded companies often make periodic quarterly or yearly cash payments to their owners, the shareholders, in direct proportion to the number of shares held. According to US law, such payments can only be made out of current earnings or out of reserves (earnings retained from previous years). The company decides on the total payment and this is divided by the number of shares. The resulting dividend is an amount of cash per share. The dividend yield is the dividend paid in the last accounting year divided by the current share price.
If a stock paid out $5 per share in cash dividends to its shareholders last year and its price is currently $50, then it has a dividend yield of 10%.

Historically, at severely high P/E ratios (such as over 100x), a stock has NO (0.0%) or negligible dividend yield. With a P/E ratio over 100x, and supposing a portion of earnings is paid as dividend, it would take over a century to earn back the purchase price. Such stocks are extremely overvalued, unless a huge growth of earnings in the next years is expected.

The P/E & Inflation

There is evidence that the P/E of the market has more to do with changes in consumer prices than any other factor. From 1900 to 2005, the highest average P/E occurred when the average change in consumer prices was 2.6%. In general, the P/E ratio is inversely proportional to the absolute value of the change in prices, in other words, the higher the price change, the lower the P/E. so inflation is directly affected by this.

Some claim that the P/E ratio is mostly dictated by interest rates, but the level of correlation of P/E ratios to interest rates is much lower versus that to the magnitude of price change.

Market P/E Ratio

To calculate the P/E ratio of a market index such as the S&P500, it is not accurate to take the "simple average" of the P/Es of all stock constituents. The preferred and accurate method is to calculate the weighted average. In this case, each stock's underlying market cap (price multiplied by number of shares in issue) is summed to give the total value in terms of market capitalization for the whole market index.

The same method is computed for each stock's underlying net earnings (earnings per share multiplied by number of shares in issue). In this case the total of all net earnings is computed and this gives the total earnings for the whole market index. The final stage is to divide the total market capitalization by the total earnings to give the market P/E ratio.

The reason for using the weighted average method rather than 'simple' average can best be described by considering a recessionary period of the economic cycle, where a number of stocks would be reporting a loss. For example, a company with a share price of $100, may have made a slight loss of say 10 cents giving a P/E ratio of -1000 (100/0.1). In another case, a company with a share price of $1 may have made a serious loss of 50 cents giving a P/E ratio of - 2 (1/0.5). This mathematical anomaly would create a misrepresentation of the underlying company losses on the overall market index.

Determining Share Prices

Share prices are determined by market supply and demand, and thus depend upon the expectations of buyers and sellers. Among these are:

-The company's future and recent performance
-New product lines
-Prospects for companies of this type, the "market sector"
-Prevailing moods & fashions.

By dividing the price of one share in a company by the profits earned by the company per share, you arrive at the P/E ratio. If earnings move up in line with share prices (or vice versa) the ratio stays the same. But if stock prices gain in value and earnings remain the same or go down, the P/E rises. For example, if a stock price was $70 per share and it got $2 in earnings, the P/E is 35, historically high.

The price used to calculate a P/E ratio is usually the most recent price. The earnings figure used is the most recently available, but this figure is often a year old and does not necessarily reflect the current position of the company. Many times, you will hear this referred to as a trailing P/E, because it involves taking earnings from the last four quarters.

It is possible, however, to use the earnings estimate for the next four quarters. When doing so, the ratio is referred to as a projected or forward P/E.

P/E Ratio

The P/E ratio of a stock ("earnings multiple", or simply "multiple", "P/E", or "PE") is used to measure how cheap or expensive its share price is. The lower the P/E, the less you have to pay for the stock, relative to what you can expect to earn from it. It is a valuation ratio included in other financial ratios.

P/E=Price Per Share/Earning Per Share

The price per share (numerator) is the market price of a single share of the stock. The earnings per share (denominator) is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. The EPS used can also be the "diluted EPS" or the "comprehensive EPS"

For example, if stock A is trading at $24 and the Earnings per share for the most recent 12 month period is $3, then the P/E ratio is 24/3=8. Stock A said to have a P/E of 8 (or a multiple of 8). Put another way, you are paying $8 for every one dollar of earnings.
It is probably the single most consistent red flag to excessive optimism and over-investment. It also serves, regularly, as a marker of business problems and opportunities. By relating price and earnings per share for a company, one can analyze the market's valuation of a company's shares relative to the wealth the company is actually creating.

One reason to calculate P/Es is for investors to compare the value of stocks, one stock with another. If one stock has a P/E twice that of another stock, it is probably a less attractive investment. But comparisons between industries, between countries, and between time periods may be dangerous. To have faith in a comparison of P/E ratios, one should compare comparable stocks.