The price-earnings (P/E) ratio, or earnings multiple, is one of the most popular measures of company value. It is computed by dividing the current stock price by earnings per share (EPS) for the most recent 12 months.
It is followed so closely because it relates the market’s expectation of future company performance, embedded in the price component of the equation, to the company’s actual recent earnings performance.
The greater the expectation, the higher the multiple of current earnings investors are willing to pay for the promise of future earnings.
The relative P/E ratio approach looks back at the relationship of the P/E ratio of a stock either to the:
a) P/E ratio of the overall market or
b) P/E ratio of the company’s industry
It is determined by dividing a company’s P/E ratio by that of the market or industry. Based on relative growth and risk expectations, companies trade at multiples greater or smaller than that of the market or industry multiple.
One would expect a company with prospects better than the market, or with lower risk, or both, to have a higher P/E ratio than the market. Comparing a firm to its industry is an equally useful technique that has the benefit of isolating interesting candidates within a specific industry.
Changes in the relative levels of the P/E ratio may signal that the market, for whatever reason, is changing its expectations about the future earnings potential of a firm, or not paying attention and mispricing the security.
A relative P/E above 1.0 indicates that a company’s P/E ratio is above the market’s ratio and vice versa. When it comes to investing, you want to find companies with a relative P/E above 1.0.
→ Read more about Relative P/E on meetinvest and see how a portfolio would have performed using the success formula.