Demystification of the economy | What is the use of a price/earnings multiple in the stock market?

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Martin Vallière

Martin Vallière
Press

I would like someone to explain to me the concept of the price/earnings multiple, which is often used in various forms by analysts and equity portfolio managers in the stock market. How is this price/earnings multiple calculated? Also, can multiple price/earnings comparisons between companies in the same sector be used to compare their high price level or not in the stock market?

André Nema and Louise Voisard

The price/earnings multiple (p/b) (we usually see the English abbreviation P/E) evaluates the relationship between a company’s earnings per share and its share price on the stock market. This makes it one of the most widely used metrics for comparing securities by investors based on their market value.

“This is a simple and practical tool for getting a quick overview of a company’s value compared to its stock market peers. However, for well-informed investors, the p/b multiple is a very short-term measure that does not properly value a company based on its performance and its long-term business prospects,” warns Yannick Clerwen, assistant portfolio manager at investment firm GPS Medici.

The basic calculation of a stock’s P/E multiple consists of two components: the stock’s current price divided by the company’s net earnings per share over the past four quarters.

In their advice to investors, some analysts sometimes use a variation on the P/E multiple, which instead takes into account the company’s expected earnings per share over the next four quarters.

How is earnings per share calculated?

In essence, this is how much shareholders would receive per share if the company paid them all of its annual net income.

For example, if a company had a net income of $100 million in 2021 and that company had 50 million shares outstanding, the earnings per share (EPS) for fiscal year 2021 would be $2.

As for the P/E multiple for this company, it is calculated using this amount of earnings per share – $ 2 – as a divisor of the current price of its shares on the exchange.

If its unit price per share is $40 and its last net earnings per share (year-on-year) was $2, then the company’s price-to-earnings multiple would be 20 ($40 per share divided by $2 in earnings per share) .

For equity investors, this p/e value, which is a multiple of 20, means that the shares of this company are trading at a price of 20 times the annual earnings per share.

This multiple can then be used as one of the benchmarks of that company’s market value relative to its peers, as well as the stock market as a whole.

“This is one of the main problems with using the P/E multiple as a unit of measure to compare the market value of companies. We need to make sure that we have truly comparable EPS performance based on the characteristics of each company and its sector of activity,” said Mark Nowakoff, portfolio managers at investment firm Jarislowsky Fraser.

For example, when accounting for earnings per share, the debt of the corresponding company is not taken into account. This company’s P/E multiple will not reflect its debt ratio relative to peers.

Thus, even if two companies have equivalent P/E multiples in the stock market, the more heavily indebted company of the two companies may be more vulnerable to good business continuity.

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