How a Stock Price Can Rise While Its P/E Ratio Falls
A P/E ratio can fall when EPS grows faster than the share price. Align actual and forecast earnings bases, then calculate the estimate risk behind a lower multiple.
The price-to-earnings ratio (P/E, or PER) equals the share price divided by earnings per share, so it falls when EPS rises faster than the price. However, comparing a historical P/E with a next-year forward P/E can make a simple change in the earnings basis look like undervaluation.
Move both the numerator and denominator
To calculate the percentage change in P/E, divide the share-price growth factor by the EPS growth factor, then subtract 1. If the share price rises 20% and EPS increases 50%, P/E becomes 1.2 divided by 1.5, or 0.8 times its previous level. That means P/E has fallen 20%; it does not mean the stock’s risk of loss has fallen 20%. This formula is intuitive when comparing positive EPS figures. When a company moves from a loss to a profit, growth rates themselves can mislead, so first distinguish the earnings amounts and whether the multiple can meaningfully be used.
Identify why earnings per share increased
EPS can rise because of operating earnings growth, but also because of a reduction in the share count, asset disposals, or tax effects. IAS 33’s treatment of EPS provides a basis for checking both the weighted-average share count and whose earnings are included. In your analysis, also calculate EPS assuming earnings are unchanged and only the share count changes. Separating improvements in operating performance from share repurchases lets you assess business growth and capital policy independently, even when both produce the same fall in P/E.
Recalculate with lower forecast EPS
When a forward P/E looks low, check whether the earnings estimates were updated close to the share-price reference date. If performance has weakened but estimates have not yet been cut, the low P/E may be provisional. Look for information that could change the earnings assumptions, such as raw-material prices or canceled orders, and retain a calculation using lower EPS. Even if the forecast proves accurate, high earnings at a cyclical peak may not last. Distinguish a single year’s multiple from normalized earning power over several years.
Worked example
Hypothetical example: At a share price of KRW 30,000 and annual EPS of KRW 2,000, P/E is 15x. If the share price then rises 20% to KRW 36,000 and EPS on the same basis rises 50% to KRW 3,000, P/E falls to 12x. But if KRW 3,000 is next year’s forecast and actual EPS reaches only KRW 2,400, P/E returns to 15x at the same share price. State whether both calculations use the same accounting scope and annual period, and record the KRW 3,000 EPS forecast separately from the reduced KRW 2,400 EPS assumption.
What to check
- Align whether both P/E ratios use actual or forecast earnings.
- Check whether EPS is basic or diluted and whose net income is included.
- Separate the effects of a lower share count and one-time gains.
- Calculate how much P/E rises if EPS is revised down.
Sources and primary materials
This is educational material about research methods. For an actual company decision, verify the filings and primary sources for the relevant period.