PE, Price Per Earnings, Price To Earnings, P/E.. Whatever

Who doesn't know this ratio? This is one of the few measures that even the most amateur investors look at when deciding their investment placements.

PE is useful. Yes, I agreed. But sometimes it tends to paint a very incomplete and skewed picture of the relationship between the performance of the stock price and business profitability.

There are at least 3 issues when making use of PE ratio.

• PE isn't meaningful when the earnings are negative.


• Some part of the earnings that're contributed by seasonal, cyclical or other volatibility factors can't be explained by PE ratio.


• Some accounting practices might results in different management discretion in treating same pecuniary items in their financial accounts might distorted the earnings amount and thus the PE ratio.

In the PE literature, there are 2 famous versions of PE ratio. Basically, they are different in their formula denominator.

1. Trailing PE

PE = (Market Price per Share) / (Most recent 12 months Earnings)

2. Leading PE aka Future PE or Prospective PE

PE = (Market Price per Share) / (Earnings in next expected period)

Trailing PE is the one we commonly seen in major newspapers, stock historical performance analysis, trading sites and etc. This PE is benchmarked to past performance, and all of us should know that past performance doesn't guarantee similar future achievements.

Constrast to Trailing PE, Leading PE is the one that is derived from Dividend Discount Model (DDM) when we divide the equation with expected earnings.

DDM Price Valuation Model

P0 = D1 / ( k - g)

P0 = Share Price at time 0
D1 = (Dividend at Time 1)
k = (Equity Required Rate of Return)
g = (Dividend Growth Rate)]

... Divide the equation with E1

Where E1 = Expected Earnings at Time 1

We get

P0/E1 = (D1/E1)/(k-g)

Which when described in words means,

Leading PE is equals to the Expected Dividend Payout Ratio (D1/E1) over the difference between the required rate of return and divident growth rate.

One precautionary note is to look out when considering firms to invest is to analyze other financial ratios might bring out the truth about the business.

Some ratios to observe:

• Price to Book Value, P/BV


• Price to Cash Flow, P/CF


• Debt Ratio


• Current Ratio, Quick ratio and Cash Ratio


• Not to forget also Asset Turnover

Besides that, some operational practices such as inventory methods (FIFO, LIFO, other) and OPEX/CAPEX expenditures must be thoughtfully considered.