The price-to-earnings ratio (P/E) is among the most important and commonly used valuation metrics in the fundamental analysis of stocks. It is also referred to as the price multiple, or the earnings multiple. Benjamin Graham, known as the father of value investing and the mentor of Warren Buffett, helped to popularize the P/E ratio. In this article, we’ll explain the meaning of P/E ratio and how it can help guide your investment decisions.
What is Price-to-Earnings Ratio (P/E Ratio)?
The P/E ratio compares a stock’s price to its earnings. By showing the relationship between a company’s stock price and earnings per share (EPS), the P/E ratio helps investors to value a stock and gauge market expectations. The average market P/E ratio is 20-25 times earnings.
Stocks with high P/E ratios may suggest that investors are expecting higher earnings growth in the future. While stocks with high P/E ratios are attractive to growth investors, stocks with low P/E ratios are appealing to value investors because it means they are paying less for every dollar of earnings they receive.
Why Use the Price-to-Earnings Ratio?
The P/E ratio gives investors insight into whether a stock may be overvalued, appropriately priced, or undervalued and is a useful means of comparing stocks, especially within the same industry. P/E ratios can be applied to both stocks and stock indices such as the S&P 500 or the Nasdaq 100.
How to Calculate P/E Ratio?
The P/E ratio of a stock can be determined by using the company’s price per share and its earnings per share (EPS). Earnings per share is a company’s net profit divided by the number of outstanding common shares. Earnings per share can be either ‘trailing’ or ‘forward’. Trailing P/E ratio (the most widely used form) is based on the earnings of the previous 12 months, while the forward P/E ratio uses forecasted earnings.
The formula for P/E ratio is as follows:
Now that we know the formula, let’s walk through calculating the P/E ratios of two similar stocks. Imagine there are two companies (Company X and Company Y) that both make and sell air purifiers.
Firstly, we’ll calculate the earnings per share (EPS) by using the earnings figures and the number of outstanding shares issued.
- Earnings: Company X earns $4 million per year and Company Y earns $5 million.
- Outstanding shares: Company X has 500,000 outstanding shares and Company Y has 400,000 outstanding shares.
With $4 million in earnings and 500,000 outstanding shares, Company X has an EPS of $8 (4,000,000/500,000).
With $5 million in earnings and 400,000 outstanding shares, Company Y has an EPS of $12.50 (5,000,000/400,000).
Having determined the earnings per share (EPS) of each company, we can calculate the P/E ratios for each company’s stock. For this we use the share price and the EPS:
- Share price: Company X is trading for $80 per share and Company Y is trading for $90 per share.
- Earnings per share: Company X has an EPS of $8 and Company Y has an EPS of $12.50.
We can now determine the P/E ratios by dividing the share price by the EPS.
- The P/E ratio of Company X is 10 (Share price of 80/EPS of 8). This means that its stock is trading at 10 times its earnings per share.
- The P/E ratio of Company Y is 7.2 (Share price of 90/EPS of 12.50). This means that its stock is trading at 7.2 times its earnings per share.
You do not actually need to do the calculation yourself as many finance websites such as investing.com will tell you the P/E ratio of a stock, along with other metrics including EPS, outstanding shares and dividend.
How to Use the P/E Ratio?
In the example of air purifier companies above, although Company Y has a higher stock price, it may be a better investment because it has a lower P/E ratio. This is because the lower the P/E ratio, the less an investor is paying per dollar of a company’s overall earnings.
A high P/E ratio signals that a company’s stock price is high relative to its earnings. This reflects that investors anticipate high earnings growth. But if the company cannot keep up with growth expectations, the stock may be viewed as overvalued and see a reversal in price, as investors lose confidence. A low P/E ratio indicates that the current stock price is low relative to earnings. If growth beats expectations the stock may be viewed as a bargain and attract buyers.
The ranges of P/E ratios vary widely by sector and industry group. For example, software companies have relatively high P/E ratios, since a fast growth rate is often expected. A high P/E ratio may reflect that investors anticipate rapid growth. Conversely, insurance companies usually have lower P/E ratios since they typically do not grow as fast. Low P/E ratios may reflect that investors see limited growth potential.
P/E ratios help to define stocks as either growth or value investments. For example, Tesla (TSLA) with a relatively high P/E ratio of 78 at the time of this writing, could be classified as a growth investment. General Motors (GM), with a current P/E ratio of 7, could be considered a value investment.
What is a Good Price to Earnings Ratio?
P/E ratios are most useful in comparing similar companies within a sector or industry. In this sense, judging what is a good P/E ratio is relative.
For example, if the average P/E ratio for the banking sector is 13 and an individual bank stock has a P/E ratio of 25, the bank may be overvalued and more likely to come under pressure if it fails to meet growth expectations. Meanwhile, another bank with a relatively low P/E ratio for the sector may be undervalued and likely to rally if it beats growth expectations.
Limitations of Price-to-Earnings Ratio
The P/E ratio, like other popular valuation metrics, has advantages and limitations. A high P/E ratio does not necessarily mean a stock is overvalued. If a company with a high P/E ratio meets the growth expectations implied in its price it can prove to be a good investment. Likewise, a low P/E ratio does not guarantee that a stock is undervalued.
While P/E ratios provide important insights into the value of stocks, investors should be cautious about making decisions based on P/E ratios alone. Other important data points to consider along with P/E ratios include dividends, projected future earnings, and the level of debt at a company.
In addition, investors should keep in mind that the trailing P/E ratio (the most widely used form) is based on past data and there is no guarantee that earnings will remain the same. There is also a potential danger that accounting figures have been manipulated to create misleading earnings reports. When using a P/E ratio based on projected earnings (a forward P/E) there is a risk that estimates are inaccurate.
The absolute P/E ratio is the most commonly used form and represents the P/E of a 12-month time period. Relative P/E compares the current absolute P/E to a benchmark or a range of past P/Es over a set time period such as the last 5 years. The relative P/E ratio gives greater perspective by drawing from a broader range of data.
Earnings yield is defined as Earnings Per Share (EPS) divided by the stock price. In other words, it is the inverse of the P/E ratio. While the P/E ratio is useful in valuing a stock, the Earnings Yield provides insight into the rate of return on the investment.
Consider the following example:
The stock of Company X is trading at $15 and its EPS for the past year was 60 cents, meaning that it has a P/E ratio of 25 (15/0.6) and an earnings yield of 4% (0.6/15).
The stock of Company Y is trading at $24 and has an EPS of $2, meaning that it has a P/E ratio of 12 (24/2) and an earnings yield of 8% (2/24).
We can see from this example that the stock of Company Y may be a better investment, since its P/E ratio is lower and its earnings yield is higher. The earnings yield of 8% means that Company Y generates 8 cents of earnings for each dollar invested at $24/share in its stock.
When used in isolation, a high P/E ratio may make companies look overvalued compared to others. Since different industries have different rates of earnings growth, this may be misleading. The PEG Ratio, which divides the P/E ratio by the earnings growth rate is used as a better means of comparing companies with different growth rates. Initially introduced by Mario Farina in his book A Beginner’s Guide To Successful Investing In The Stock Market, the PEG ratio reflects how cheap or expensive a stock is relative to its growth rate.
The formula is as follows:
PEG Ratio = Price/Earnings divided by Annual EPS Growth
Consider the following example:
Company X has a price per share of $52 and an earnings per share of $2.50 for this year and $2.20 for last year. The means that Company X has:
- P/E Ratio of 20 (52/2.5 = 20)
- Earnings Growth Rate of 13% (2.50/2.20 – 1 = 13%)
- PEG Ratio of 1.5 (20/13 = 1.5)
Company Y has a price per share of $79 and an earnings per share of $3 for this year and $2.30 for last year.
- P/E Ratio of 26 (79/3 = 26)
- Earnings Growth Rate of 30% (3/2.30 – 1 = 30%)
- PEG Ratio of 0.86 (26/30 = 0.86)
In the example above, Company X has a lower P/E ratio, but Company Y has a lower PEG ratio reflecting that investors are paying less per unit of earnings growth. This may indicate that Company Y is a better investment from a growth perspective. PEG ratios of less than 1 are considered to be a signal that a stock is undervalued.