The Price-to-Earnings (“PE”) ratio is calculated by dividing a company’s market price per share by the earnings per share. This ratio indicates how much an investor would be willing to pay for each monetary unit of the company’s earnings. The PE multiple is a valuation tool that allows investors to benchmark a company’s valuation against its peers or industry standards. However, PE multiples are not appropriate in all situations. This article considers the specifics of PE multiples, when they are most useful, and where alternative valuation methods might be more appropriate.
The PE multiple is both straightforward to calculate and widely recognised. It relies on readily available inputs: a company’s share price and earnings per share, which are regularly updated for publicly traded companies. These characteristics make the PE multiple one of the most commonly used valuation metrics, valued for its simplicity and accessibility.
While the PE multiple is a powerful valuation tool, it has notable limitations that can impact its reliability. First, it relies on positive earnings, which may not exist for companies in the early stages of their life-cycle. For the PE multiple to be meaningful, the entity must have stable earnings; however, early-stage and cyclical companies often experience volatile earnings, leading to potentially misleading valuations. Additionally, the PE multiple is based on historical earnings, which may not accurately represent a company’s future prospects. These limitations highlight the need to think carefully about when and how to use the PE multiple, ensuring it is part of a broader and more thorough valuation process.
When to use PE Multiples
PE multiples are most effective in the following scenarios:
- where the entity is mature and profitable. Indicators of a mature and profitable business include stable and positive earnings and low growth variation. These characteristics are largely displayed by companies that are in the later stages of their business life cycle.
- when comparing similar companies within the same industry. The PE ratio is often used to compare similar companies within the same industry, as it helps to standardise valuations across competitors.
Whilst PE multiples are popular, they may not be appropriate in the following circumstances:
- High-growth companies often reinvest earnings into expansion and further projects, which can lead to negative earnings in the early years. PE multiples therefore may not reflect the full value of the company’s potential.
- Certain companies operate within cyclical industries, resulting in the companies experiencing earnings fluctuations based on cycles within the market. This can distort the PE ratio at certain points within that market cycle.
- The PE multiple does not consider a company’s capital structure. Based on this, highly leveraged companies may have higher earnings due to tax advantages on interest payments.
PE multiples are best suited for valuations of mature, profitable companies with stable earnings and low growth volatility. PE multiples are also appropriate where quick, relative valuations within the same industry are required. However, when dealing with high-growth, cyclical, or highly leveraged companies, it is often more insightful to use alternative valuation methods. It should, however, be noted that a comprehensive view of a company’s value and potential is more reliable when multiple valuation methods and qualitative factors are considered.