What is and How to Interpret the Price/Earnings Ratio

Price to Earnings ratio is a valuation model used to determine how expensive or cheap a stock is trading for. The P/E ratio is a model for valuing a company's performance because it compares current stock price divided by the company's earnings per share. The formula for price to earnings ratio is:

P/E ratio = Current Market Stock Price / Earnings per Share (EPS)

As an example, if a corporation's stock is currently trading at $50 per share and its earnings per share for 2009 was $2.58/share, then the price to earnings ratio will be:

P/E ratio = Current Market Stock Price / Earnings per Share (EPS)
P/E ratio = $50 / $2.58
P/E ratio = 19.40

You can look at this number 19.40 in this way: For every $1 the company earns in its net income, you will be paying 19.4 times that much to own a share in that company (a share of stock). Earnings per Share (EPS) is usually tabulated from the previous 4 quarters of operating results (trailing P/E) or it could be an estimate in to earnings in the future 4 quarters (forward P/E). Some analysts even mix the actual EPS of the previous 2 quarters, and the estimates of 2 quarters in to the future, thus mixing the past & future results together.

The price to earnings ratio is sometimes also simply known as the "price multiple" or "earnings ratio."

Interpret the Price/Earnings Ratio

A high PE ratio means investors are expecting higher growth of earnings from the company, and that's why they are paying higher prices for the stock (paying a premium). It is essential to compare the P/E ratios of companies within the same industry to see which one is trading at a premium and which one is discounted. For example if you are wanting to buy stocks in the Computer Hardware sector, then you would compare two companies in the Computer Hardware sector. This is opposed to say comparing a computer hardware company to a Utility company.

The price/earnings ratio is also referred to as the "Multiple" because it shows how much investors are willing to pay per each dollar of earnings. For example, a stock trading at 23 times multiple means investors are paying $23 per share for every $1 of earnings the company generates in its net income.

Price/Earnings Ratio of Chipotle Mexican Grill, Inc. (Public, NYSE:CMG)

Let's do a real life example of Chipotle Mexican Grill which is a fast growing food chain across the United States and the world. As of midday June 29, 2010, the stock is trading at $138.85. As of March 31st, 2010, the company reported earnings per share of $4.36. Knowing this data, we can easily compute the price/earnings ratio using the formula we presented above:

P/E ratio = Current Market Stock Price / Earnings per Share (EPS)
P/E ratio = $138.85 / $4.36
P/E ratio = 31.85

This means for every $1 the company earns in its earnings, investors are willing to pay $31.85 per each share of stock; quite expensive huh? To make this analysis more useful, we tabulated the price/earnings ratio of companies operating in the same business line as Chipotle Mexican Grill. Here's the data

In the fast food chain industry, we see the most expensive stock is Rubio's Restaurants (Public, NASDAQ:RUBO) which is trading a price/earnings ratio of a whopping 167.96! The company only earned 5 cents a share in its latest quarter and the stock is trading at less than $10 a share. With a market capitalization of only $84.80 million, Rubio's Restaurants looks like a speculative play that has been overbought by investors.

Similar competitors to Chipotle Mexican Grill that are worth looking at from the table above are Yum Brands (Public, NYSE:YUM) and McDonalds (Public, NYSE:MCD). Yum Brands is trading at 17.52 times multiple while McDonalds is trading at 15.69 multiple. This means when you compare Chipotle Mexican Grill's P/E of 31.85 and McDonald's P/E of only 15.69, you would be paying double for Chipotle Mexican Grill's stock in terms of earnings. Here's how we calculated this:

Chipotle vs McDonalds P/E = 31.85 / 15.69 = 2.03 times

Doing analysis like this is useful for investors who are wanting to see how expensive a stock is trading versus similar competitors in its industry.