By analyzing the price-to-earnings ratio, investors can evaluate a company's shares within the context of actual income the company has generated over a certain period.

One of the most popular tools that analysts use to determine whether a company shares are overvalued or undervalued is the Price-to-Earnings (P/E) ratio. The reason why is that investors are very interested in knowing what is the present value of their future returns. In other words, investors can evaluate a stock by determining how much they are willing to pay today for the company's expected earnings in the future.

Calculating Price-to-Earnings Ratio

Calculating the ratio is fairly simple: a stock’s market price per share is divided by its earnings per share (EPS). Through this formula, analysts can figure out how many times over investors are willing to pay for each dollar of a company’s earnings. This is why this ratio is also often referred to as the earnings multiple.

When calculating current P/E ratio, analysts usually rely on earnings per share going back at least the last four quarters. However, investors are far more interested in knowing how a stock might, or might not, perform in the future, which is when analysts have to rely on a company's management estimates of future earnings per share, going forward at least four quarters. If that is the case, we are talking about the projected or forward P/E ratio.

Of course, the moment "management's estimates" are introduced into the equation, forward P/E calculations should be taken with a grain of salt. EPS forecasting represents an inherent conflict of interest for a company's management, and thus, it should not be taken at its face value and without further analysis of the company's fundamentals and other financial ratios.

A good place to look for information about what caused the earnings to decline are footnotes to financial statement or the Managements Discussion and Analysis (MD&A). However, both documents will give you only a general idea and further "digging" for information may be required.

Understanding the Concept of Earnings Multiple

What can be learned from P/E ratio is best demonstrated on an example. Let’s say that you have identified a company called Mama Knows Best Inc., and you think it will give you a dollar from its earnings from now to eternity.

So, you ask yourself, how much that dollar is worth to you now, this moment, this minute? After you look at few of the company’s key ratios, including the P/E ratio, you determine that Mama Knows Best’s dollar in future earnings is worth to you about $0.50 today. After all, it is not the same as if that dollar is coming from Microsoft or Google, right?

But that is precisely the point! The real question is how much would you be willing to pay if that dollar was actually coming from Microsoft? In all likelihood, you would probably be willing to pay much, much more than $0.50 cents on a dollar. Actually, you might be willing to pay $15.00 or $20.00 for the privilege of receiving a dollar from Microsoft’s earnings in perpetuity. In financial lingo, it means that Microsoft’s P/E ratio is 15 or 20, and that Mama Knows Best’s is 0.50.

Interpreting P/E Ratio

Typically, the higher the P/E ratio, the higher the expected future earnings! But what does it mean when a company is trading at a high earnings multiple of 100 or more? Here are a few possible scenarios that could explain such a high P/E ratio.

The company with a high earnings multiple could be an established gold mining company, for example, which has a mine lined up to become active in the current quarter and which is expected to yield 250,000 ounces of gold per year for the first year, and between 300,000 and 350,000 ounces per year after that for an expected lifespan of 20 years. In addition, the company has estimated the mine's cash costs to be approximately $200.00 per ounce. Considering that gold’s current market price is over $700.00 per ounce, it could very well be the reason why investors are willing to pay good money to buy that company’s shares.

There is also one "slightly" sinister scenario, when a company, after experiencing a major shock to its bottom line, decides to take the “big bath,” which is an accounting measure often used by management to manipulate earnings. Namely, instead of expensing the "charge" over more than one accounting period, the company may decide to absorb if fully and all at once, (hence the expression "big bath"), thus significantly lowering its earnings per share for the current period.

The idea is that after the initial shock wears off, investors would believe this charge was a one time occurrence only, after which earnings would have nowhere else to go but up. Laboring under the assumption the stock is undervalued, buyers could flock to buy the company’s shares, therefore pushing up both the share's market price and its earnings multiple.

Before we part, there is one more thing that needs to be addressed. Investors already know what a stock market bubble looks like, feels like, and especially what happens when it bursts. Bubbles are created when investors rush to buy stocks at much higher prices and earnings multiples than their fundamentals would ordinarily justify.

This is exactly what has happened during the tech bubble of the late 1990s, when technology stocks were trading at ridiculously high multiples. Historically speaking, bubbles have a tendency to resolve themselves in costly crashes, which is why we feel obligated to remind you of the cliche that when things are too good to be true, that is because, far too often, they simply are!

For readers interested in learning more on P/E ratios, please read the article Price-to-Earnings Ratio Expanded.

(Source: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, 2005; Analysis of Equity Investments: Valuation, by John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey, 2002)