What it means
A price-earnings ratio on its own is hard to judge, because market-wide valuations rise and fall over time. A P/E of 20 may look expensive in a gloomy market and cheap in an optimistic one.
Dividing by the benchmark's P/E removes that background movement and leaves the company's valuation in context. If the relative is above 1.0, investors are paying a premium compared with the benchmark.
If it is below 1.0, the shares trade at a discount. A relative of 1.2 means the company's P/E is 20% higher than the benchmark's.
Investors often compare the current relative with the company's own history. If a stock has usually traded at a relative of about 1.0 and now stands at 1.4, they ask whether growth has improved enough to justify the premium or whether the shares have become expensive.
The reverse question applies when the relative falls below its usual range. The measure also helps managers understand how the market views their business.
A persistent discount may reflect concerns about debt, customer concentration or weak growth. A persistent premium may bring benefits such as cheaper equity funding, but it also creates pressure to deliver.
The relative inherits the weaknesses of the P/E, including distortion from one-off items and differences in accounting. The choice of benchmark also matters, since comparing a small technology firm with a broad market index tells a different story from comparing it with other technology firms.
The relative can also be tracked as a time series. Plotting it each quarter shows when the market began to treat the company differently, and that date can then be matched to events such as an acquisition, a change of chief executive or a profit warning.
In practice
Real-world examples.
Example
A fund manager notes that a utility company has a relative of 0.7 against the market. She checks whether the discount reflects genuine weakness or just the sector's usual lower growth before buying.
Example
A chief financial officer of a retail group sees its relative rise from 0.9 to 1.3 over two years. She prepares the board for higher investor expectations on sales growth.
Example
An analyst covering banks compares each lender's P/E with the sector average. The bank with a relative of 0.8 turns out to hold a large pile of risky loans, which explains the market's caution.
Formula
Calculation
Price-earnings relative = Company P/E / Benchmark P/E.
A company trades on a P/E of 18, and the benchmark index trades on a P/E of 15. The relative is 18 / 15 = 1.2, meaning the company trades at a 20% premium to the benchmark.
Suppose the company's relative has averaged 1.0 over the last decade. If the benchmark P/E stays at 15 and the company's P/E moves to 21, the relative becomes 21 / 15 = 1.4, a 40% premium. If instead the company's P/E falls to 12, the relative is 12 / 15 = 0.8, a 20% discount. Note that the relative can change even if the company's P/E stays at 18: if the benchmark P/E falls from 15 to 12, the relative rises to 18 / 12 = 1.5, because the whole market has become cheaper.Case study
Seen in the real world.
Harbourview Telecom is a fictional communications company. In an illustrative review, its relative P/E against the national index fell from 1.1 to 0.75 over three years, even though profit was growing steadily.
The finance director asked an adviser to find the cause. Investor feedback showed worries about heavy borrowing for a new network, which made the market apply a discount to the company's earnings.
The fictional board responded by selling a non-core division and using the proceeds to cut debt. The relative recovered to 0.95 within a year, which illustrated how a valuation gap can reflect risk perception and not just profit.
Watch out
Common mistakes.
- Using a poorly matched benchmark, such as comparing a small manufacturer with a broad index dominated by large technology firms.
- Treating any relative below 1.0 as undervalued, when the discount may be justified by lower growth or higher risk.
- Ignoring the company's own history, which is often the best guide to what a normal relative looks like.
Questions
People also ask.
What does a relative of 1.0 mean?
The company's P/E equals the benchmark's, so the market values its earnings in line with the benchmark.
Which benchmark should I use?
Use an industry average or a market index that reflects similar businesses, and use the same one over time.
Can the relative be negative?
Not usually, because it is only meaningful when both P/E ratios are positive. If either the company or the benchmark has negative earnings, analysts normally leave the relative out rather than interpret a distorted number.
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