The P/E ratio and its alternatives

Key takeaways

  • The P/E ratio measures a company’s share price against its earnings.
  • Comparing a book value – earnings – with a market value – price can be ineffective at times and can create confusion, which is why this measure is often taken into account alongside price to cash flow, price to sales, enterprise value to EBITDA and price to book as a way to improve accuracy.
  • Private market investments – such as Yieldstreet’s product offerings – are not valued using P/E ratios as they do not normally trade on secondary markets. 
Slight movements can mean big profits

Often considered a key tool for the valuation of individual stocks or stock indexes, the price-to-earnings ratio (P/E ratio) can give investors an idea of whether the market is over- or undervaluing an asset’s worth. It also reveals what the market is willing to pay to invest in a company, based upon its past or future earnings. 

Calculating a P/E ratio

The price of a publicly traded stock is a known quantity – it’s the market price at a certain point in time.  

Earnings are whatever is left for shareholders once the company has paid all of its expenses and made all its debt payments. It can be 12-month trailing (TTM) – which measures past year performance – or forward, which is usually an estimate.   

A more accurate P/E ratio measures price against average past earnings over a number of years.  

In general, retail investors usually prefer to look at forward P/E ratio, though most industry players agree that trailing P/E is the most objective measure, as it is based upon actual performance, rather than on an “educated” guesstimate. 

There is no “good” or “bad” P/E ratio, as for the most part, average P/E ratios vary depending on the specific sector or industry. While it is often seen as an indication of a company’s potential, the ratio can be misleading as companies with high growth potential can become incredibly “expensive” (reach an extremely high P/E ratio) if more investors believe in the company’s high growth trajectory.  

The P/E ratio can at times be skewed by a number of factors such as market volatility – which influences price – the earnings makeup of the company in question and earnings growth. This is why it becomes important to look at additional measures such as dividends, projected future earnings and other relevant data points rather than relying solely upon a P/E ratio to determine the company’s value.

PEG ratio

An analysis of a company’s current earnings and its expected growth rate can help investors determine whether a stock is overvalued or undervalued. This equation is called the PEG (price/earnings ratios and earnings growth) ratio

A PEG calculation can provide a more complete picture of the relationship between a company’s P/E ratio and earnings growth. However, growth rate is a projection, rather than a known quantity. Therefore, it should only be looked upon as an estimate. 

Financial theory assigns a PEG ratio of one as the theoretical equilibrium of a stock’s market value and its projected earnings growth. As an example, a stock with an earnings multiple of 15 (P/E of 15) and 15% in projected earnings growth has a PEG ratio of 1. Using this logic, a stock with PEG of less than 1 could be considered undervalued, while a PEG that’s greater than 1 could be considered overvalued. 

Other valuation metrics

Price to cash flow (P/CF) indicates the amount of cash a company is generating – which is hard to manipulate –  in relation to its share price. A company with a share price of $15 and a cash flow per share of $3 has a PC/F of 5 .  

Price-to-sales (P/S) is calculated by dividing the stock price by the number of sales per share. This can be useful as a comparative metric when considering companies that lack a positive net income, such as startups or distressed firms

The ratio of enterprise value to earnings before interest, taxes, depreciation, and amortization is called EV-to-EBITDA. Enterprise value (EV) is the sum of a company’s market capitalization, preferred shares, minority interest and debt, from which the total cash on hand is subtracted. 

Price-to-book (P/B) is the ratio of a share price relative to company’s equity – divided by the number of shares. Book value can be a better gauge of a company’s status – it doesn’t suffer from the volatility of market fluctuations – but while a low P/B ratio can be seen as a positive, it may also indicate that investors have no faith in the company’s potential to generate revenues into the future. 

P/E ratios and alternative investments

Given the elevated P/E valuations of certain public stocks – especially in the tech space – seeking diversification in private markets can help investors diversify from crowded growth stock investments. 

Yieldstreet was founded with the goal of improving access to alternative assets by making them available to a wider range of investors. While traditional portfolio asset allocation envisages an allocation of 60% public stocks and 40% fixed income, a more balanced 60/20/20 or 50/30/20 split may make a portfolio less sensitive to public market short-term swings. In addition to that, by being a platform for a variety of asset classes in the alternative investments space, Yieldstreet aims to offer the opportunity to diversify within the private market space.

Learn more about the ways Yieldstreet can help diversify and grow your portfolio.

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