Investors can look at a company’s price-to-earnings ratio, often stylized as “P/E ratio,” among many other metrics, to help determine if a stock is a worthy investment. This figure gives an investor a quick read on how much a stock costs compared to that company’s profitability, or the earnings.
However, the price-to-earnings ratio alone does not tell investors everything they need to know about a stock and whether it is a sound investment. But the ratio is a helpful tool available for all investors when analyzing stocks.
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Key Points
• The price-to-earnings ratio is calculated by dividing the current stock price by earnings per share.
• A high P/E ratio may indicate investor confidence in a company’s growth potential.
• A low P/E ratio could indicate that a company’s stock is underpriced and represents good value.
• The P/E ratio is one of many indicators used in stock analysis and should not be used alone for investment decisions.
• The formula for calculating price-to-earnings is: Price to Earnings Ratio = Current Stock Price ÷ Earnings per Share.
What Does the P/E Ratio Tell You?
The price-to-earnings ratio (sometimes written as the P/E ratio, PER, or P/E) is a ratio of a company’s current share price relative to the company’s earnings per share (EPS). This ratio provides investors with an understanding of how the market feels about a company (stock price) compared to the company’s profitability (EPS). It’s also one of several financial ratios.
One of the main benefits of the P/E ratio is that it gives investors and analysts a way to compare different companies on a more level playing field. The stock price or earnings alone may not be adequate to compare investments, but the P/E ratio, and other valuation methods, can be used to compare the valuations of companies in similar sectors.
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How to Calculate the P/E Ratio (Formula & Examples)
The formula for calculating price-to-earnings is fairly simple:
Price to Earnings Ratio = Current Stock Price Ă· Earnings per Share
The price-to-earnings ratio is calculated by dividing a company’s current stock price (P) by the company’s earnings per share (E).
An investor can find the company’s current share price by looking up the stock’s ticker symbol on any search engine or financial website.
The EPS of a company can also be found on a financial website, but investors should be aware that there are different ways to calculate this figure.
Generally, the EPS is calculated by using a company’s earnings over the previous year, usually called the trailing 12 months (TTM). It is also possible to calculate EPS using the earnings guidance that a company provides in its quarterly earnings release. These are called forward earnings or forward-looking earnings.
These different versions of EPS determine the trailing and forward P/E, respectively.
If a company has yet to report earnings or is reporting losses, then its P/E ratio will be N/A, or not applicable.
Example of P/E Ratio Calculation
Company XYZ has a current stock price of $10 per share. The company’s earnings per share was $2 for the previous twelve months. In this example, Company XYZ would have a P/E ratio of 5, which is $10 per share divided by $2 per share.
$10 per share Ă· $2 per share = 5 P/E
With the data related to earnings and stock prices, an investor can calculate P/E with relative ease.
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How to Interpret a Stock’s P/E Ratio
Being able to calculate P/E ratio is one thing — being able to interpret it and put it to use as a part of an investment strategy is another.
What is a Good P/E Ratio?
There is no “good” P/E ratio, and the current P/E ratio of a company doesn’t provide much information alone. A high or low P/E ratio does not necessarily make one stock a more attractive investment over the other.
To determine if a P/E ratio suggests a good investment opportunity, an investor may compare it to similar stocks, the overall market, or a company’s past performance.
Why You Should Compare P/E Ratios Within the Same Industry
Investors may find it useful to compare P/E ratios between companies operating in the same industry, for example, an auto manufacturer versus another auto manufacturer, or a big-box retailer against another big-box retailer. This is because “normal” or “typical” P/E ratios may vary between industries. A high P/E ratio in one industry may not be an outlier, in other words, but it may be a big red flag (or green flag) in another.
Comparing companies in the same industry can help you get an idea of what a typical P/E ratio is, in those cases.
What a High P/E Ratio Might Mean
If the current P/E ratio of a company is high relative to its past P/E ratio or compared to similar companies, it could be an indication that the stock is overvalued. An overvalued stock could mean that investor exuberance boosts the stock price, especially if earnings remain low, thereby suggesting poor value.
However, a high P/E ratio may indicate widespread investor confidence in a company’s position to grow and expand. This high ratio can indicate a growth stock, where investors believe the company’s future earnings will be higher than current profitability.
What a Low P/E Ratio Might Mean
If the current P/E ratio of a company is low, it could indicate that the company’s stock is underpriced and represents a good value. Some analysts believe that stocks with relatively low P/E ratios present buying opportunities, allowing investors to purchase an undervalued stock that still has strong earnings. Investors seeking out these value investments expect a potential for share price growth.
On the other hand, the low P/E ratio may also indicate that investors are actively selling shares and driving the price down. Such a wide-scale selloff would suggest that investors are losing confidence in the stock, and a low P/E is a red flag.
Types of P/E Ratios
There are two main P/E ratios: the trailing P/E and the forward P/E. These ratios use different measures of EPS depending on whether an analyst is interested in the past performance of a company (trailing P/E) or the future earnings of a company (forward P/E).
Trailing P/E
The trailing P/E relies on examining the past performance of a stock. It is calculated by dividing the current share price by the earnings per share over the past 12 months (TTM). Some analysts prefer the trailing P/E because it’s based on actual earnings performance rather than guidance that a company may provide.
However, the trailing P/E may be a misleading indicator because a company’s past earnings performance doesn’t necessarily predict future results. Investors want to put their money where they expect future earnings power, not the past.
Forward P/E
The forward P/E uses future earnings guidance rather than a company’s previous earnings. This forward-looking ratio can be helpful because investment decisions are frequently made based on future expectations rather than past results.
But this doesn’t mean the forward P/E is a flawless indicator. The forward P/E can be problematic because companies may miscalculate earnings expectations, and external analysts may miss on earnings forecasts for a company.
Where to Find a Stock’s P/E Ratio
You can calculate a company’s P/E ratio yourself, if you have the relevant variables, which can likely be tracked down through financial statements or quarterly reports. You can also find P/E ratios on various financial news websites or stock exchange pages.
P/E Ratio Comparison
Though popular, the price-to-earnings ratio is just one of many indicators that investors use when analyzing stocks.
P/E Ratio vs P/S Ratio
The price-to-sales ratio (P/S ratio) is calculated by dividing a company’s current stock price by the company’s revenue per share. Another way to determine the P/S ratio is by dividing the company’s market capitalization by the company’s total revenue. So, while the P/E ratio looks at a company’s bottom line, the P/S ratio is concerned with a company’s top line.
The P/S ratio provides an alternative to the P/E ratio that can be useful when analyzing companies that are young and yet to make a profit. When a company shows negative earnings, they do not have a P/E ratio. The P/S ratio fills that void.
In general, a lower P/S ratio suggests that a company is a more attractive investment, though there’s no guarantee that is the case.
P/E Ratio vs EPS
Earnings-per-share (EPS) is the denominator of the P/E ratio equation. EPS is the bottom line of a company, indicating its profitability. It is calculated by dividing a company’s net profit by the number of its common shares. By looking at a company’s EPS over time, an investor can see how the company’s profitability is changing.
Though the EPS metric is good for comparing a company’s profits over time, it can also be misleading when a company repurchases or issues new stock. Those moves could raise or lower the EPS, respectively, even if the net income stays the same.
When evaluating stock performance, it may be a good idea to examine both the P/E ratio and the EPS.
Pros and Cons of Using P/E Ratio
As mentioned above, there are benefits and drawbacks to using the P/E ratio to evaluate stocks. Here are some of the pros and cons of using the P/E ratio.
|
Pros and Cons of Using P/E Ratio |
|
|---|---|
| Pros | Cons |
| Easy to calculate | Based on earnings from the past, or potentially misleading forecasts |
| Widely used by investors and analysts as an indicator of potentially undervalued or overvalued stocks | Can’t be used for companies that have no net income |
| Helps investors compare stocks | Doesn’t factor in other financial metrics, like debt |
What Are the Limitations of the P/E Ratio?
The P/E ratio is useful for investors, but does have its limitations. Those limitations include the fact that it is merely a snapshot in time, and doesn’t capture a company’s momentum — that is, whether it’s growing or contracting. It ignores debt, too, and could potentially be the result of accounting manipulation. Further, it can’t be used for companies that have no revenue. Further, it’s possible that
Again: It’s not foolproof, and investors should do their due diligence when evaluating a stock.
The Takeaway
The P/E ratio is a useful metric for investors when evaluating stocks. The ratio can help an investor wrap their heads around the value of a stock and how it compares to similar companies. However, the metric is just a starting point, and investors shouldn’t make decisions based on a stock’s P/E ratio alone.
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FAQ
In simple terms, what does the P/E ratio mean?
P/E ratio tells investors how a company’s revenue relates to its share price, and can be used as an indicator that a stock is either over or undervalued.
Is a PE ratio of 10 good or bad?
A P/E ratio of 10 means that a stock is trading at ten times the company’s annual profits.
Can a P/E ratio be negative?
It’s possible that a P/E ratio is negative, and that would happen if a company reported a net loss or negative earnings per share in their respective financial statements or reports.
What is the average P/E ratio for the S&P 500?
The average P/E ratio of the S&P 500 changes all the time, but recently, it’s approximately between 25 and 30, according to available data.
What’s the difference between a P/E ratio and a PEG ratio?
The P/E ratio compares earnings per share to the company’s stock price, while the PEG ratio attempts to incorporate future earnings growth into the mix. PEG is actually a derivative of P/E ratio.
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