Posted at 9:00 a.m.
I would like someone to explain to me the concept of the price/earnings multiple, which is frequently cited in various forms by analysts and managers of equity portfolios on the stock market. How is this price/earnings multiple calculated? Also, can the comparison of multiple prices/earnings between companies in the same sector be used to compare their level of high price or not on the stock market?
Andrée Nehma and Louise Voisard
The price/earnings (p/b) multiple (we commonly see the English acronym P/E) assesses the relationship between a company’s earnings per share and the price of its share on the stock market. This makes it one of the most widely used metrics for investors to compare securities based on their stock market value.
“It’s a simple and practical tool to get a quick overview of a company’s value compared to its peers on the stock market. However, for well-informed investors, the p/b multiple is a very short-term measure that does not allow a company to be properly assessed on the basis of its results and its long-term business prospects”, warns Yannick Clérouin, assistant portfolio manager at the investment firm GPS Medici.
The basic calculation of the p/e multiple of an exchange-traded stock consists of two components: the current price of that stock divided by the net earnings per share made by the company during its last four quarters.
In their advice to investors, some analysts sometimes use a variant of the p/e multiple which instead considers a company’s expected earnings per share over its next four quarters.
How is earnings per share calculated?
Essentially, it is how much shareholders would get per share if a company paid them all of its annual net profit.
For example, if a company’s net income in 2021 was $100 million and that company had 50 million shares outstanding, the earnings per share (EPS) for its 2021 fiscal year would be at $2.
As for the p/e multiple for this company, it is calculated using this amount of EPS – $2 – as a divisor against the current price of its shares on the stock exchange.
If the unit price of its shares is $40 and its most recent net earnings per share (annualized) was $2, the company’s p/e multiple would be 20 ($40 per share divided by $2 in EPS).
For stock investors, this p/e multiple of 20 means that shares of this company are trading at a price of 20 times annualized earnings per share.
This multiple can then be used as one of the comparative measures of market value of this company compared to its peers, but also compared to the stock market in general.
“This is one of the main challenges of using the p/e multiple as a unit of measurement for comparing market value between companies. We have to make sure that we have EPS figures that are truly comparable based on the particularities of each company and its sector of activity,” points out Mark Novakoff, portfolio managers at the investment firm Jarislowsky Fraser.
For example, the accounting of net earnings per share does not take into account the debt of the company concerned. This company’s p/e multiple will not reflect its debt ratio relative to that of comparable companies.
Thus, even if two companies have equivalent P/E multiples on the stock market, the more indebted company of the two could in fact be more vulnerable for the good continuity of its business.
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