The price-earnings ratio (P/E Ratio) is a ratio used to value a company that measures its current share price relative to its per-share earnings (profit per share). The ratio can be calculated as:
Market Value per Share (Share Price) / Earnings per Share (EPS)
Essentially, the P/E ratio is meant to show how much investors are willing to pay per dollar of earnings. In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.
The first question many have when seeing the above formula is “what happens to the P/E ratio when a company has negative earnings?”. This is an excellent question! Although companies with negative earnings can technically have negative P/E ratios, the standard practice is to display ‘N/A ‘, or show no ratio for that quarter’s P/E. However, a single quarter of negative earnings can skew the P/E for the next 3 quarters (when earnings are later positive and P/E is again displayed), since the metric adds the trailing 4 quarters of earnings; this means that a negative quarter can make the denominator (EPS) of the above equation very small, sending the P/E ratio through the roof. I’ll highlight a couple current examples below when I split out the companies with the highest P/E ratios, which may make this point easier to follow.
P/E ratio by sector
The below chart shows us the various average P/E ratios across sectors, for the largest ~500 publicly traded companies. At first glance, looks like Materials and Health Care companies have sky high P/E ratios:
However, if we bring in the standard deviation of the P/E values in each sector, we see that Materials and Health Care both have very high standard deviations, meaning some companies likely have unreasonably high P/E ratios (I’ll get into the cause of some of these outliers below).
So, since our averages are skewed due to outliers, the median P/E would probably be a better metric to use:
As we can see, P/E varies pretty significantly between the different sectors, with Real Estate, Energy, and Health Care topping the list. It’s worth noting that P/E ratios can vary across sectors due to differing ways in which companies earn money, and differing timelines in which that money is earned; as a result, P/E is best used as a comparative tool when considering investing in companies within the same sector.
That said, I did pull the top 10 companies with the largest P/Es below, in an attempt to highlight some of the reasons a company’s P/E can be several standard deviations above its sector average.
Which companies trade at the highest P/E ratios? (making sense of unreasonably high P/E ratios)
At first glance, one may look at Glaxosmithkline or Rio Tinto and think investors must either be crazy or expect a tremendous amount of future earnings growth, since the companies are trading at 1.2-3k multiples of earnings. However, a deeper look shows that Glaxosmithkline had negative net income in 2 of the last 4 quarters, while both Rio Tinto and Kinder Morgan also had a negative net income quarter at some point in the last year. (note this is the example I mentioned I’d cover at the beginning of this post)
Basically, companies with sky high P/E fall into these basic groups:
The takeaway from this is that P/E ratios should definitely be paired with other metrics to get the complete picture. Many financial metrics can skew for a variety of reasons, and this is helps illustrate how important it is to avoid simply looking at a single financial metric and pulling the trigger on an investment.
Also, for those interested I pulled the 10 companies trading at the lowest P/E multiples (note they mostly fall into sectors that bottomed out our list above)
Which companies trade at the lowest earnings multiples? (are expected to grow the least)