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The PE Ratio explained |
The PE Ratio, or P/E ratio, is shorthand for the Price : Earnings ratio of a company, which is calculated as the market capilisation of the company divided by the total annual earnings of the company, and simplistically reflects the number of years earnings which are contained in the market capitalisation (or alternatively calculated as the price for one share divided by the annual earnings per share).
The higher the P/E ratio of a company the more you are paying for each net unit of earnings. Companies which are expected to have higher earnings growth usually have a higher P/E ratio. If a company has a P/E ratio twice that of another company, then everything else being equal (especially expected earnings growth) the company with the lower P/E ratio is a more attractive investment. Investors are also willing to pay more for stable earnings than uncertain earnings (e.g. earnings due to high leverage).
There are various definitions of earnings which can be used in calculating the P/E ratio:
Trailing P/E ratio : Earnings = net income for the most recent 12 month period, for which there is reported net income (if somebody is talking about a PE ratio without defining which, they usually mean the trailing P/E ratio)
Forward P/E ratio : Earnings = estimated net earnings over the next 12 months, with estimates typically from a select group of analysts. An issue over this measure is that analysts are bad at predicting downturns and are usually over-optimistic of earnings growth. This wouldn't be as bad if forward P/E's were compared with historic forward P/E's, and analysts upward biases were consistent. However, those with agendas to make equities appear cheap or who don't have a full understanding of what they're doing, often compare forward P/E ratios against trailing P/E ratios, making equities look cheaper than they actually are.
P/E 10 years : Earnings = average earnings over the last 10 years adjusted for inflation, reflecting the view that this may be more representative of what the earnings going forward may be, as the latest earnings may be an abherration, it is also in line with the theory that earnings revert to average earnings - a capitalistic system doesn't allow high profit margins to last, as new businesses will start up to try to capture those profits, driving margins back down. This is the measure I prefer using.
We can see that in the US at least, historic returns have been lower from a starting point of a higher PE (10 years). 
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