Price-to-Earnings (P/E) Ratio: Basic Valuation Metrics
Diversification decides the weights. Order types decide the fill. The P/E ratio asks whether the price you just paid is justified by the earnings the company is actually producing. It is a ratio, not a verdict.
🗺️ Two weeks ago the question moved off the single stock. Diversification is the free lunch that still sends a bill: combine holdings that do not move together, accept less variability, and pay for it in fees, tax, complexity and a smaller chance of a one-name win.
Last week the question moved to execution. Market, limit and stop orders are the instructions that turn a decided weight into a fill, or leave it unfilled. The price you actually paid is the price that enters the cost base.
This week the question is whether that price was justified by the earnings. The price-to-earnings ratio is the most widely used single number for that check. It is also the number most easily misread.
The Calculation
The arithmetic is simple. Divide the current share price by earnings per share.
A stock trading at US$200 with trailing earnings of US$10 per share has a trailing P/E of 20. You are paying US$20 for each dollar of last year’s reported earnings.
A forward P/E uses estimated earnings for the next twelve months instead of the last twelve. Both versions answer the same question — how much are you paying for a unit of earnings — but they answer it with different information. Trailing uses what has already been reported. Forward uses what analysts or the company expect. Neither is a guarantee that the earnings will continue at that rate.
The ratio is useful because it normalises price. A US$50 stock and a US$500 stock can be compared once both are expressed as a multiple of their own earnings. It is less useful when the earnings are distorted.
A company that just took a large one-off charge will show a high or meaningless trailing P/E. Imagine the same US$200 stock reporting only US$4 of earnings after a non-recurring write-down. The trailing P/E jumps to 50. The underlying business may be unchanged; the number is not. A company that is growing quickly will show a high forward P/E that may be justified if the growth arrives. A company that is shrinking will show a low P/E that may be a value trap. The number does not tell you which of those is true. It only tells you the price relative to the earnings figure you chose.
Two Practical Limits for Australian Holders of US Stocks
Currency. The earnings are reported in US dollars. The price you paid is converted to Australian dollars on the day of purchase for capital-gains purposes. A rising AUD reduces the Australian-dollar cost base of a past purchase and compresses the apparent multiple when you translate everything back. A falling AUD does the opposite.
A 10% rise in the AUD after you bought, for example, lowers the AUD cost base of that parcel. When you later convert the position back for tax purposes, the multiple looks lower than the USD screen P/E you saw on the day of purchase. The P/E you see on a US screen is not the multiple that will appear in your tax working if the exchange rate has moved. The earnings multiple and the currency multiple are separate.
Earnings are not cash. A company can report rising earnings while free cash flow declines because of higher capital expenditure, working-capital absorption, or share-based compensation. The P/E uses the accounting earnings figure. It does not adjust for the cash that must be reinvested to keep those earnings growing. For the AI infrastructure names in this series, the distinction is material. High multiples can be justified by high growth and high incremental returns on capital. They are harder to justify if the growth requires ever-larger capital outlays that do not drop through to free cash flow.
A Simple Decision Framework
🔘 Have you calculated both the trailing and the forward number, and noted the source of the earnings figure? → Starting point only.
🔘 Does the multiple still look reasonable once you strip out one-off items and ask what growth rate is required to make it sensible? → Continue with the earnings.
🔘 Is free cash flow tracking the earnings, or is the growth being funded by rising capital intensity that never reaches the cash flow statement? → The multiple is incomplete.
🔘 Is the AUD/USD rate that applied on your purchase date still the rate that will set your cost base? → Separate the currency overlay from the earnings multiple.
The order type got you the price. The P/E asks whether the earnings support it. Next week the question moves to how much the portfolio will move when the market does.
Data Sources:
- Company filings and earnings releases (trailing EPS)
- Analyst consensus estimates (forward EPS — source-dependent)
- ATO: Cost base and capital gains tax on foreign shares (AUD conversion on acquisition date)
- Free cash flow and capital expenditure disclosures in company reports
Wall St. Down Under | Australia
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Disclaimer: Wall St. Down Under is an independent financial newsletter for informational and educational purposes only. Nothing published here constitutes financial advice, a recommendation to buy or sell any security, or a solicitation of any investment decision. Always do your own research and consult a licensed financial adviser before making investment decisions. Australian investors should consider their own financial situation, objectives, and risk tolerance. Past performance is not indicative of future results.
