The ratio of a stock’s market price per share to its EPS is termed its price-to-earnings (P/E) ratio. Investors often use P/E ratios as a basis for attempting to detect over- or under-valued securities. Analysts often suggest that firms with low P/E ratios may be undervalued, while firms with high P/E ratios are likely to be overvalued. Kerr-McGee’s market price per share at the end of 1997 was $63, and its 1997 EPS was reported at $4.04. The resulting P/E ratio is:
P/E = Price per share / EPS
= $63 / $4.04
This result indicates that Kerr-McGee’s stock was selling at a price that is 15.6 times its earnings per share.
P/E ratios are often used to assess growth, risk, and earnings quality. How would we expect Kerr-McGee’s P/E ratio to compare to those of other firms? To answer this question, we must consider the effects of growth, risk, and earnings quality on interfirm comparisons of P/E ratios.
Growth and the P/E Ratio
P/E ratios vary directly with expected future growth rates in earnings. If investors expect a firm’s future earnings to grow rapidly, then the current earnings understate the future earning power of the firm. Stock price, on the other hand, reflects investor expectations of future earnings and cash flows. Consequently, the ratio of prices to earnings will be relatively high for firms with high expected
rates of earnings growth.
Risk and the P/E Ratio
It is well established among investors that riskier investments require higher returns. Lenders require higher interest payments from borrowers with lower credit ratings, and equity investors demand greater returns and therefore pay lower prices for the stocks of risky firms. For this reason, high-risk firms are expected to have lower-than-average P/E multiples, and low-risk firms are expected to exhibit higher-than-average P/E multiples.
Earnings Quality and the P/E Ratio
Earnings quality refers to the sustainability of currently reported earnings in future periods. Firms that use conservative methods of income measurement (LIFO inventory costing and accelerated depreciation and amortization) are more likely to be viewed as having higher earnings quality than firms that use more liberal income measurement methods. The securities market is likely to place a higher share price on firms with quality earnings. In other words, P/E multiples should vary directly with firms’ earnings quality. The market price is based on the expectations of investors about a company’s future performance.