How to Calculate the P/E Ratio for Investment Banking
If there’s a famous valuation ratio in investment banking, it’s the price-to-earnings or P/E ratio. Even regular individual investors are often familiar with P/E ratios, and they use them as a guide to indicate when a stock is richly valued or arguably undervalued. The P/E ratio at its essence is a simple division problem:
The P/E ratio tells investment bankers how much investors are willing to pay for a claim to a dollar of a company’s earnings. The higher the P/E ratio, the more richly valued a company and its stock are.
At its heart, the P/E ratio is simple, but it can quickly get complicated as you dig deeper. The numerator of the ratio, the stock price, is something everyone can agree on. Investment bankers can obtain the stock price from any quote service. But the denominator, a company’s earnings, is subject to debate.
Individual investors often look at forward P/E ratios, which are the stock price divided by how much the company is expected to earn over the next year. But investment bankers tend to look at things a bit differently.
Investment bankers often want to look at P/E in a purer form that’s based on hard numbers from the financial statements. For that reason, it’s common for investment bankers to zero in on P/E based on historical earnings minus any extraordinary items.
That means investment bankers divide the stock’s current price by a company’s diluted earnings per share excluding one-time items (such as restructurings, divestitures, and another non-recurring items). A company’s diluted earnings per share excluding one-time items is often calculated as follows:
Diluted Earnings per Share Excluding One-Time Items = (Total Revenue − Cost of Revenue − Operating Expenses + Interest Expense − Income Tax Expense − Preferred Dividend + Unusual Items) ÷ Diluted Shares Outstanding
A company’s diluted shares outstanding is a tally of all the shares there might be of a stock in the wild if all claims to the company were converted — including executives’ stock option grants, outstanding warrants, and convertible bonds converted into common stock. The diluted shares outstanding can be obtained directly from a company’s balance sheet.