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Price/Earning Per Share (P/EPS or P/E) is one of the most popular ratios in the investment sector because it is easy to calculate and a good start for a company performance analysis.

EXAMPLE

If stock price is 45 Euro and earning per share is 5 Euro, P/EPS is 9.

Investors are willing to pay 9 Euro to have 1 Euro of earning.

The best choice is between 10 and 20 although this usually changes from industry to industry; for example, technology industries often have P/EPS between 30 and 40.

Why are investors happy to pay 9 Euro or more to receive 1 euro of earning?

This question can have different answers, and an investor needs to investigate further to understand better P/EPS result.

It is usually helpful to start with a comparison between P/EPS and the following indicators:

P/E historical trend of the company;

P/E results of the competitors in the same industry;

P/E of the sector.

EXAMPLE

Company A: stock price=50 Euro

Company B: stock price=35 Euro

The two companies operate in the same sector

**Is Company B cheaper than Company A?**

If

P/E of Company A is 22

P/E of Company B is 31

Company B is not cheaper than Company A because investors will pay less the stock of company A to receive 1 Euro of earning.

If the two companies are similar (same risk profile, same future growth rate), an investor should buy the stock of company A.

However, the market may predict that Company B will continue growing more than company A and for this reason, investors are willing to pay a higher price.

In this situation, investors are happy to pay 31 Euro the stock of Company B to receive 1 euro of earning because they believe in its growth prospect.

Investors pay high prices because they believe that these companies have excellent growth prospects.

These companies usually operate in growing sectors and are subject to high volatility; they are considered riskier than mature companies.

Companies that operate in mature sectors, usually present low P/E because they do not have high growth prospects.

Undervalued companies have also low P/E. In this situation, the market does not adequately test the fundamentals and the future growth trends of those companies, and it quotes their price less than their real value. Value investors usually digging through financial statements and sector analysis to find companies undervalued and take advantage of the possibility to buy at a low price and sell their stocks in the future at a high price.

Net income can be distorted one year for a one-off event (for example, sell off a subsidiary, buy of another company); these costs/revenues should be taken out to analyse the trend of P/EPS correctly.

When EPS is calculated, it is best practice to be conservative about the number of shares outstanding and determine a diluted EPS instead of a basic EPS. Basic EPS uses the number of shares outstanding in the denominator, while fully diluted EPS considers the number of fully diluted shares. Dilutive securities are securities that are not common stocks but can be converted into them if the holder will exercise this option. If they will be converted, dilutive securities will increase the weighted number of shares outstanding with the consequence that EPS will decrease (because the earning will be shared among more stocks) and P/EPS will increase.

P/EPS can present two variations: a trailing P/EPS and a forward P/EPS. The key difference between trailing P/E and forward P/E is that trailing P/E is based on the last 12 months of actual earnings, while forward P/E is based on the next projected 12 months of earnings. It is useful to compare the two measures to determine if there is an ascending or declining trend in the projected P/E versus the baseline trailing P/E figure. The forward price-earnings ratio is usually considered less reliable in particular if the company provides the estimates. Managers can be excessively optimistic or pessimistic based on the figures they are interested in showing. For this reason, many analysts compare P/EPS forecast of the previous year with the actual P/EPS to understand how accurate was the company’s prediction.

PEG ratio compares the price of a stock, the earnings generated per share (EPS) and the company’s expected growth.

As the price of a stock incorporates the potential company’s growth, a P/EPS high could be a sign of a company with great potential but also a company overvalued………….. PEG ratio can help to explain P/EPS result!

For example, if a company is growing at 15% a year (in real term) and has a P/E of 15, it would have a PEG of 1.

PEG ratio of 1 indicates that the stock is reasonably priced given the expected growth.

PEG ratio with a result higher than 1 indicates a possible stock overvalued.

PEG ratio between 0 and 1 indicates a possible stock undervalued.

PEG ratio can have a negative number if the present net income is negative or future earnings are expected to drop (negative growth). This result is perceived with scepticism and indicates a high-risk investment.

The main criticism to PEG ratio is related to the calculation of the EPS growth rate because it incorporates discretional decisions that can influence the result.

In particular, if the company calculates the growth rate, it can be influenced by the managers who can underestimate or overestimate it based on their interest.

Furthermore, if EPS growth rate is calculated over a short period (as usually happens), it can be altered by short term events and not reflect the long growth trend by which the stock price is influenced.

Finally, it is important to highlight that earning is not considered the ultimate driver of a value of a company that is the Free Cash Flow, in particular, if the company has a significant amount in non-cash expenses (amortisation and depreciation) and capital expenditures.