Valuation & P/E ratio

This metric looks at the relationship between the market value of a company and a financial metric like earnings. The aim is to show you the price you are paying for some future stream of revenue/cash flow. For example, if you pay $100 for a company that expects to generate $200 a year, then the company is cheap because the P/E ratio is 0.5x (the S&P 500’s P/E ~18x). Essentially, valuation ratios are based on estimates of future streams of cash flows/earnings.

Since these ratios are forward looking, you will have to make an estimate about what you and the rest of the market believe this company could potentially generate. Analyst expectations about future earnings can easily be found online and play a role in the movement of an asset’s price.

The most commonly used measure is the Price - Earnings ratio (also known as P/E or PE ratio) which looks at how much an investor pays for a single dollar of earnings. This ratio is also beneficial to compare competitors within the same industry.

Price/Earnings Ratio

The price/earnings ratio is a major relative valuation method used to compare performance between similar companies or compare periodic performance within a company. This ratio is calculated as the current share price divided by the earnings per share (EPS). Sometimes referred to as the earnings multiple, investors use this ratio to observe the relative value of a company’s shares.

A high P/E could indicate that a company is overvalued or analysts expect high future growth rates. There are 2 types of P/E ratios - forward and trailing P/E. Trailing means that these are real earnings that the company has produced in the last 12m or last fiscal year. Forward refers to the expected earnings per share of a company, based on the mean/median earnings estimated by the analysts that cover the company. The two measures each have their own drawbacks. Trailing earnings are backward looking, and forward earnings are usually just a lagging indicator based on market performance.

Another major valuation ratio is a company’s enterprise value to its earnings before interest, tax, depreciation and amortization (EBITDA). A company’s enterprise value measures the total value of a company and is calculated by adding debt and subtracting cash from a company’s market value. Overall, the ratio tells you how many times a company’s EBITDA covers the value of the business.