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Price-to-Earnings (P/E) Ratio
The price-to-earnings (P/E) ratio is a standard part of stock research that's used to determine if a stock is undervalued or overvalued. The P/E ratio is used to compare companies' stock prices within an industry or against the broader market.
The price-to-earnings (P/E) ratio is one of the most popular metrics for stock valuation. Investors use it to determine if a company is undervalued or overvalued and when comparing a stock to a competitor, its industry group or a benchmark, such as the S&P 500.
In this guide, we'll explore the P/E ratio in depth, explain how to calculate a P/E ratio and show you how you can use it to make sound investment decisions. The price-to-earnings ratio is also known as the P/E, price multiple, earnings multiple and simply “the multiple.”
What is the P/E ratio?
The P/E ratio measures a stock’s share price against the company’s earnings per share (EPS). EPS is a company's earnings, also known as net income and profit, divided by the number of outstanding shares. Earnings per share are how much each shareholder would receive if all the profits were paid to the company’s shareholders. The P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. Basically, the P/E ratio tells you the amount of money you’ll need to invest in a company to have a share that equates to one dollar of the company's earnings.
The P/E ratio is a standard part of stock research that investors use to compare company stock prices within an industry or against the broader market, such as the S&P 500. Investors also use the P/E ratio to determine if a stock is undervalued or overvalued in order to help them decide whether they should buy, sell or hold a stock.
You can also compare a company’s P/E ratio to its past performance to see how it has grown and predict how it may grow over time. The P/E ratio can also help you compare companies within an industry, but it isn't as useful when comparing companies that provide different products and services.
How to calculate the P/E ratio
The P/E ratio is calculated by dividing the market price of one share by the company's EPS. If you don't know a company’s EPS it can be calculated by dividing the company's net earnings by the number of shares outstanding.
The formula for calculating the P/E ratio is as follows:
P/E Ratio = Price Per Share / Earnings Per Share
For example, if a company's stock is trading at $100 per share, and the company generates $4 per share in annual earnings, the P/E ratio of the company's stock would be 25 (100/4).
The P/E ratio is often calculated based on historical data (trailing P/E), but it can also be calculated using estimated future earnings (forward P/E).
Trailing P/E: One way to calculate the P/E ratio is to use a company's earnings over the past 12 months. This is referred to as the trailing P/E ratio or trailing 12-month earnings (TTM), and it’s the most popular P/E metric because it uses actual, reported data. Trailing P/E can provide useful insights into whether a stock price is overvalued and whether the overall market or market index is too high or low compared to past P/Es. However, a company's past performance doesn't indicate its future results.
Forward P/E: The P/E ratio can also be calculated using an estimate of a company's future earnings. While the forward P/E ratio doesn't benefit from reported data, it uses the best available information on how the market expects a company to perform over the coming year. However, calculating forward P/E requires expertise because it involves forecasting sales, margins, profit and loss (P&L), and EPS.
What is a good P/E ratio?
There's no such thing as a good or bad P/E ratio because it's a comparison tool, not a benchmark figure. The ratio needs context to provide value — the P/E ratio is high or low only when compared to other companies in the same industry, a benchmark index, or the company's past performance.
Also, companies and industry groups can have very different P/E ratios, so a good P/E ratio in one industry or asset class can be bad in another. For example, a P/E ratio of 10 might be normal for a utility company but low for a software business. The P/E for the S&P 500 has historically ranged between 10 and 20 most of the time. It's gone as high as 124 times during bubbles, but the average multiple is 16.
High P/E ratio
Generally, a high P/E ratio means that a stock's price is high compared to previous or current earnings, meaning you're paying more to purchase a share of the company's profits. Stocks with high P/E ratios are often considered to be growth stocks. Investors who buy growth stocks expect higher future earnings growth and are willing to pay more now.
The downside is that growth stocks are often highly volatile, and companies may feel a lot of pressure to do more to justify their higher valuation. Also, a high P/E ratio may indicate an overvalued company, as P/E ratios can be very high when overall earnings fall considerably.
You’ll need to research a company further when deciding whether to buy, sell or hold a stock with a high P/E ratio. Is the high ratio a symptom of market-driven hype, or is there a good reason for investors to anticipate higher future returns?
It's also important to look at many factors, such as dividends, projected future earnings, and other data points.
Low P/E ratio
A low P/E ratio indicates that a company's current share price is low compared to its earnings, meaning an investor is paying less to get a dollar of a company's overall earnings. Companies with low P/E ratios are often considered to be value stocks. This means the company is currently undervalued — the stock price may stay the same while the company's earnings increase, sending the P/E ratio lower.
While a lower P/E ratio is attractive to investors looking for a bargain, it's important to understand the reasons behind it. For example, if a company has a low P/E ratio because its business model is fundamentally in decline, the low valuation may not be much of a bargain.
Absolute vs. relative P/E ratio
Absolute P/E is the current price-to-earnings ratio, while relative P/E compares that to some benchmark or a range of past P/E ratios. The numerator of the absolute P/E ratio is usually the current stock price, and the denominator may be the company’s EPS from the past 12 months (trailing P/E) or its estimated EPS for the next 12 months (forward P/E).
Relative P/E usually compares a stock’s current P/E ratio to the highest ratio it achieved over a time period. For example, if the highest P/E ratio of a stock in the last 10 years was 30, and the stock currently has a P/E ratio of 27, then its relative P/E will be 90%. You can also compare a stock’s current P/E ratio to its lowest historical value. Relative P/E may also compare the current P/E ratio to the average P/E ratio of a benchmark such as the S&P 500.
P/E vs. PEG ratio
One variation of the P/E ratio is the price-to-earnings-to-growth ratio, also known as the PEG ratio. One of the limits of the P/E ratio is that it fails to factor in the growth in underlying earnings. The PEG ratio makes up for this flaw by considering the current earnings and the expected growth.
The PEG ratio is calculated by dividing the P/E ratio by the expected growth rate. For example, if a company's P/E ratio is 20, and its expected growth rate is 35% over the next year, its PEG ratio is 0.57 (20/35). Generally, a stock with a PEG ratio of 1 or less is considered an undervalued investment because its price is low compared to growth expectations.
P/E vs. earnings yield
Simply put, earnings yield is the inverse of the P/E ratio. It shows how much earnings per share a company generates from every dollar invested in its stock and is calculated as earnings per share divided by price per share.
Unlike the P/E ratio, the earnings yield cannot provide any insight into the stock's valuation. Instead, investors typically use it to compare potential returns among different assets, such as fixed-income securities, and assess the rate of return on an investment. Asset managers use earnings yield to determine optimal asset allocations
P/E ratio vs. justified P/E ratio
The justified P/E ratio is a stock evaluation metric that connects the traditional P/E ratio to the Gordon growth model (GGM). While the P/E ratio compares the current valuation of a company's common stock shares to the company's earnings, the GGM estimates a stock's intrinsic value based on an assumption of future, consistent dividend growth. The key word here is “assumption.”
Determining a company's justified P/E is important as it helps determine if it's valued fairly. A justified P/E that's close to the stock's forward P/E is an indication of a fairly priced stock. However, if the justified P/E is greater than the forward P/E, the stock is likely underpriced, and vice versa.
Limitations of the P/E ratio
While the P/E ratio can be a good way for investors to evaluate companies, it has its drawbacks.
It fails to include any consideration of future earnings growth: The biggest limitation of the P/E ratio is that it doesn't take into account the company's growth prospects. For example, if a company has a high P/E ratio, it can be hard to tell if the company is expected to grow or if the stock is simply overvalued.
It doesn't provide an accurate comparison of companies in different sectors: Using the P/E ratio to compare companies across industries is challenging, as company valuations and growth rates can vary significantly between different sectors.
Market volatility affects the P/E ratio: Volatile market prices can throw off the P/E ratio in the short term. Earnings are highly dependent on a variety of factors, which can be unpredictable.
Earnings aren't always reliable: To calculate a company’s P/E ratio, you need an accurate representation of its earnings. To calculate trailing P/E, you must rely on information provided by the company, a source that can be unreliable. Companies can report positive earnings while having negative free cash flow, meaning they spend more than they earn. On the other hand, forward P/E is based on the opinions of Wall Street analysts, who are known to be overly optimistic during periods of economic expansion, and too pessimistic during economic downturns. Their projections can skew the forward P/E ratio.
It’s difficult to calculate the P/E ratio of companies with no earnings: When a company has no earnings or is posting losses, calculating its P/E ratio becomes near impossible. There's no consensus on how to address this: for a company like this, you may see its P/E ratio listed as 0, a negative number, or even as “N/A.” This is generally not useful for comparison purposes.
It completely ignores capital structure: The P/E ratio only considers the profitability and trading price of an ownership stake and ignores the cost of the capital that the company uses to drive profits. Debt affects both the company's earnings and the share price, and as a result, the P/E ratio. For example, if you're comparing two companies that are very similar except for the amount of debt they have, the one with more debt will likely have a lower P/E ratio.
The P/E ratio is just one piece of the puzzle
Although the P/E ratio is one of the most popular ways to evaluate a stock, it’s not the only indicator investors should consider. You should also consider several other factors that affect the value of a stock. This includes the current condition of the company's industry, the company's EPS growth prospects, the average P/E ratio in the stock market, the company’s debt-equity ratio, strong management team, scale of the company (small-cap, mid-cap or large-cap) and the current performance of similar companies.
You can also use other market ratios in conjunction with the P/E ratio for a more comprehensive overview of a stock. For example, the price-to-book ratio compares stock price to book value, while the price-to-sales ratio compares stock price to revenue.
P/E ratio key takeaways
Although no single metric can tell you whether a stock is a good investment, the P/E ratio is a good start. In addition to giving you a quick valuation of a company's stock price, the P/E ratio can also help you explore the stock's future direction and determine whether the price is high or low compared to other companies in that sector. Remember that the P/E ratio isn't a foolproof measure of when to buy and sell stocks, and you need to use it alongside other stock research techniques.