TechCrunch featured an opinion piece on food startups by Matt Mireles last week with the core of the argument built around comparing the PE Ratio of a technology stock to Chipotle. You can check out the comments for rebuttal of the analysis, but I wanted to discuss PE Ratios – what it means, how to use it, and does it matter.
First, the price to earnings ratio (P/E Ratio) is an equity valuation multiple defined as market price per share divided by annual earnings per share.
There are a handful of variations of this ratio, but in most cases we’re discussing “Trailing P/E” which is determined by net income for the most recent 12 month period divided by the weighted average number of common shares in issue during the period. (If the company has not issued stock in the period, you can use the shortcut of market capitalization divided by net income to get to the same answer – but this only works if the number of shares of common stock in issue hasn’t changed)
By comparing the price to earnings per share multiple, one can more easily analyze the market’s valuation of company’s shares relative to its peers. Stocks with higher or more certain growth, usually have a higher P/E than those with lower growth or certainty.
If everything about two companies was equal (except for the price of its stock), the stock with the higher P/E is a less attractive investment. The reality is that companies are rarely equal and comparisons between companies, industries, and time periods will be misleading. As such the P/E ratio is useful for comparing the valuation of similar companies within a sector or group (and usually used alongside other valuation tools)
Some drivers of P/E ratio differences (and Alternative Valuation Ratios):
Capital Structure (Debt):
Debt taken on by the company affects the company in a variety of ways including leveraging of earning growth rates, tax effects, and risk of bankruptcy. For example, for two companies with identical operations and taxation regime, and trading at typical P/E ratios, the company with a moderate amount of debt commonly has a lower P/E than the one with no debt, despite having a slightly higher risk profile, slightly more volatile earnings and (if earnings are increasing) a slightly higher earnings growth rate. An alternative valuation metric would be Enterprise Value / Free Cash Flow which would work to remove the effects of the difference in debt between two different companies.
If a company is growing quickly, its PE ratio may seem high (both to comparable companies and to the broader market.) To account for this, an alternate metric would be the PEG Ratio – which includes growth as part of the ratio calculation.