We may earn a commission for purchases through links on our site at no cost to you, Learn more.
P/E ratio key takeaways:
- Definition: The price-to-earnings (P/E) ratio represents the relationship between a company’s stock price and earnings per share (EPS).
- High P/E interpretation: A high P/E ratio can indicate that a stock is potentially overvalued or that investors anticipate significant future growth.
- Applicability: Companies without earnings or experiencing losses do not have a P/E ratio, as the calculation requires a positive EPS in the denominator.
- Types: The primary types of P/E ratios are forward P/E (based on projected earnings) and trailing P/E (based on historical earnings).
- Comparative value: P/E ratios are most useful when comparing companies within the same industry or analyzing the historical trend of a single company’s P/E ratio.
What is the Price-to-Earnings (P/E) ratio?
The Price-to-Earnings (P/E) ratio is a fundamental tool used in the financial markets to gauge the value of a company’s stock. It is calculated by dividing the current market price per share by the company’s earnings per share (EPS).
The P/E ratio offers valuable insights into how the market values a particular stock relative to its earnings. A higher P/E ratio suggests that investors are willing to pay a premium for each dollar of earnings, potentially indicating high growth expectations for the company. Conversely, a lower P/E ratio may signal that the stock is undervalued or that investors have more moderate growth expectations.
Investors often employ the P/E ratio to compare a company’s current valuation to its historical performance, its industry peers, or the broader market. This comparative analysis can aid in identifying potential investment opportunities or assessing the risk associated with a specific stock.
It’s important to note that P/E ratios can be calculated on either a trailing (using past earnings data) or forward (using projected earnings) basis. The two choices depend on the investor’s preference and investment strategy.
P/E Ratio formula and calculation
The price-to-earnings (P/E) ratio is a straightforward calculation to assess a company’s stock valuation. It is determined by dividing the stock’s current market price per share by the company’s earnings per share (EPS).
The formula is as follows: P/E Ratio = Market Value per Share / Earnings per Share
To calculate the P/E ratio, simply obtain the current market price of the company’s stock and divide it by the EPS, typically found in the company’s financial statements or financial news sources.
For instance, if a company’s stock trades at $50 per share and its EPS is $2.50, the P/E ratio would be 20 ($50 / $2.50 = 20). This means investors will pay $20 for every dollar of earnings the company generates.
Determining the stock price (P) is straightforward: simply search for the stock’s ticker symbol on a reliable financial website. This value represents the current market price investors are paying. However, the earnings per share (EPS), the other component of the P/E ratio, can vary depending on the timeframe considered.
There are two common ways to obtain EPS. Trailing Twelve Months (TTM) EPS reflects the company’s performance over the past 12 months, providing a historical perspective on earnings. Alternatively, earnings releases often include EPS guidance, which represents the company’s projections for future earnings.
These two versions of EPS give rise to two types of P/E ratios: trailing P/E and forward P/E. The trailing P/E ratio uses the TTM EPS, while the forward P/E ratio relies on the projected EPS guidance. Each type offers a different perspective on a company’s valuation, with the trailing P/E providing insights into past performance and the forward P/E reflecting anticipated future growth.
Understanding the P/E ratio
The P/E ratio is a fundamental tool for investors and analysts to assess a stock’s valuation. It helps determine if a stock is overvalued or undervalued relative to its earnings, and it can be compared to other stocks within the same industry or broader market benchmarks like the S&P 500 Index.
For long-term trends, the P/E 10 or P/E 30 measures, which average earnings over the past 10 or 30 years, can offer valuable insights. These metrics are often used to evaluate the overall value of a stock index, revealing changes over multiple business cycles.
Examining the historical P/E ratio of the S&P 500, dating back to 1927, reveals a range from a low of 5.9 in mid-1949 to a high of 122.4 in mid-2009. The long-term average P/E for the S&P 500 stands at approximately 17.6, indicating that the stocks within the index have typically been priced at over 17 times their weighted average earnings.
This average is a useful benchmark to gauge whether the market is currently valued higher or lower than historical norms. By reviewing a company’s P/E ratio, analysts and investors can assess whether the stock price aligns with the projected earnings per share, aiding in informed investment decisions.
Forward price-to-earnings
The two most common types of P/E ratios are the forward P/E and the trailing P/E. A less frequently used variation combines the actual earnings from the past two quarters with estimated earnings for the next two quarters.
The forward P/E, also known as the leading P/E, utilizes future earnings guidance instead of historical data. This forward-looking metric facilitates the comparison of current earnings to projected earnings, offering insights into potential future performance without accounting adjustments or other modifications.
However, it’s important to be aware of the limitations of the forward P/E metric. Companies might intentionally underestimate earnings to surpass the estimated P/E when the subsequent quarter’s results are released. Additionally, external analysts may provide estimates that differ from the company’s projections, creating potential discrepancies and confusion for investors.
Trailing price-to-earnings
The trailing P/E ratio, a widely used valuation metric, relies on historical data. It’s calculated by dividing the current stock price by the total earnings per share (EPS) over the past 12 months. Many investors favor this metric due to its perceived objectivity, assuming the company’s reported earnings are accurate.
However, the trailing P/E ratio has its drawbacks. One notable limitation is that a company’s past performance does not always guarantee future success. Investors often make decisions based on potential earnings rather than historical results. The trailing P/E ratio’s reliance on a fixed EPS figure, while stock prices fluctuate constantly, can be problematic. This means that significant events impacting a company’s stock price may not be reflected promptly in the trailing P/E ratio, potentially leading to an outdated view of the company’s valuation.
Another issue is the dynamic nature of stock prices, which can change whenever the market is open, while earnings are typically released quarterly. Consequently, the trailing P/E ratio may not always provide the most current snapshot of a company’s valuation. As an alternative, some investors prefer the forward P/E ratio. If the forward P/E is lower than the trailing P/E, analysts anticipate earnings growth, while a higher forward P/E suggests a potential decline in earnings.
Valuation from P/E
The P/E ratio is more than just an indicator of whether a stock is overvalued or undervalued. It also provides valuable insights into how a stock’s value compares to others within its industry or broader market benchmarks like the S&P 500.
The P/E ratio, often called the price multiple, represents the dollar amount an investor is expected to invest to receive one dollar of the company’s earnings. For example, a P/E ratio of 20x signifies that investors are willing to pay $20 for each dollar of the company’s current earnings.
Furthermore, the P/E ratio enables investors to assess a stock’s market value relative to its earnings. It reveals what the market is prepared to pay for a stock today, based on its past or future earnings. A high P/E ratio may suggest that the stock is potentially overvalued, with the price exceeding its earnings, while a low P/E ratio could indicate that the stock is undervalued, with the price not fully reflecting its earnings potential.
Examples of the P/E ratio
To illustrate the application of the P/E ratio, let’s consider FedEx Corporation (FDX). As of February 9, 2024, FDX’s stock price closed at $242.62, and its trailing 12-month earnings per share (EPS) was $16.85. Therefore, FDX’s P/E ratio was 14.40, calculated by dividing the stock price by the EPS ($242.62 / $16.85 = 14.40).
Comparing companies within the same industry using the P/E ratio can offer further insights. For instance, on the same date, Hess Corporation (HES) had a stock price of $142.07 and a diluted 12-month trailing EPS of $4.49, resulting in a P/E ratio of 31.64. This indicates that HES was trading at approximately 31 times its trailing earnings.
However, this P/E ratio alone doesn’t provide a complete picture. It’s crucial to compare it to relevant benchmarks, such as the industry average, a benchmark index like the S&P 500, or the company’s historical P/E range. In this case, HES’s P/E ratio was notably higher than the S&P 500’s P/E ratio of 22 on the same date.
Comparing HES to a peer like Marathon Petroleum Corporation (MPC), which had a P/E ratio of 7.195 on February 9, 2024, reveals a significant difference. HES’s much higher P/E ratio could suggest that it’s overvalued compared to MPC or that investors anticipate significantly higher earnings growth for HES in the future.
It’s important to remember that the P/E ratio is just one tool in a comprehensive investment analysis. A thorough evaluation should involve multiple financial metrics and considerations to determine a stock’s fair value before making investment decisions.
Investor expectations
Generally, a high P/E ratio suggests that investors anticipate higher earnings growth for a company than those with lower P/E ratios. Conversely, a low P/E ratio could indicate that a company is undervalued or performing exceptionally well relative to its past results. In cases where a company has no earnings or is experiencing losses, the P/E ratio is typically expressed as “N/A” (not applicable), as it cannot be calculated. Although it’s mathematically possible to calculate a negative P/E ratio, it is not a common practice.
The P/E ratio also serves as a tool to standardize the value of $1 of earnings across the stock market. By analyzing the median P/E ratios over an extended period, one can establish a benchmark P/E ratio. This benchmark can then be used to assess whether a particular stock is potentially a good investment opportunity.
A “N/A” P/E ratio indicates that the ratio is not available for a company’s stock. This could occur for several reasons, such as a company being newly listed on the stock exchange and not having reported earnings yet, as is often the case with initial public offerings (IPOs). Companies with zero or negative earnings will also have an N/A P/E ratio.
P/E vs. earnings yield
The earnings yield is the inverse of the P/E ratio, calculated by dividing the earnings per share (EPS) by the stock price and expressing it as a percentage. It essentially represents the earnings generated for each dollar invested in a stock.
For example, if Stock A trades at $10 and has an EPS of $0.50, its P/E ratio is 20, and its earnings yield is 5%. In contrast, if Stock B trades at $20 with an EPS of $2, its P/E ratio is 10, and its earnings yield is 10%.
Although the earnings yield provides insights into the return on investment, it’s less commonly used than the P/E ratio, especially among equity investors prioritizing capital appreciation over periodic income.
However, the earnings yield proves valuable when evaluating companies with zero or negative earnings, which is often true for high-growth or early-stage companies. In such scenarios, the P/E ratio becomes undefined (N/A), whereas the earnings yield, even if negative, can still offer a basis for comparison.
P/E vs. PEG ratio
While the P/E ratio, even when calculated using forward earnings estimates, provides valuable insights, it doesn’t always reveal whether the P/E aligns with a company’s expected growth rate. To address this, investors often turn to the Price/Earnings-to-Growth (PEG) ratio.
The PEG ratio offers a more comprehensive view by considering the relationship between the P/E ratio and earnings growth. It helps investors determine whether a stock is overvalued or undervalued by analyzing current earnings and the company’s projected growth rate. The calculation divides the trailing P/E ratio by the earnings growth rate for a specific period.
Because the PEG ratio incorporates both historical earnings and future growth projections, it is often considered more informative than the P/E ratio alone. For instance, a low P/E ratio might initially suggest a stock is undervalued, but factoring in the company’s growth rate through the PEG ratio could reveal a different perspective. PEG ratios can be classified as “trailing” when using historical growth rates or “forward” when based on projected growth rates.
While earnings growth rates can differ across sectors, a general guideline is that a stock with a PEG ratio below one is typically considered undervalued, as its price is relatively low compared to its expected earnings growth. Conversely, a PEG ratio exceeding one might indicate overvaluation, suggesting the stock price is too high relative to the company’s anticipated earnings growth.
Absolute vs. Relative P/E
Analysts often differentiate between absolute P/E and relative P/E ratios in their assessments.
The absolute P/E ratio typically uses the current stock price as the numerator, while the denominator can be either the trailing twelve-month (TTM) EPS, the estimated EPS for the next 12 months (forward P/E), or a combination of both. Essentially, the absolute P/E represents the P/E ratio for the current period. For example, if a stock’s current price is $100 and its TTM earnings are $2 per share, the absolute P/E ratio is 50.
In contrast, the relative P/E ratio compares the current absolute P/E to a benchmark or a range of past P/E ratios over a specific period, such as the past 10 years. This provides context by showing how the current P/E compares to previous levels as a percentage of the highest past P/E or the lowest past P/E.
If the relative P/E is below 100%, it signifies that the current P/E is lower than the historical benchmark, whether that benchmark is the highest or lowest value within the chosen timeframe. Conversely, a relative P/E of 100% or higher indicates that the current P/E has reached or exceeded the past value, providing insights into the stock’s valuation relative to its historical performance.
Limitations of using the P/E ratio
While the P/E ratio is a valuable tool for evaluating stocks, it’s essential to be aware of its limitations. One challenge arises when dealing with companies that are not profitable or have negative earnings per share (EPS), making it impossible to calculate a standard P/E ratio. Analysts have no consensus on handling this situation; some suggest using a negative P/E, others assign a P/E of 0, while most simply state that the P/E is not applicable (N/A) until the company becomes profitable.
Another significant limitation of the P/E ratio is its use in comparing companies across different sectors. Valuation and growth rates can vary significantly between industries due to differences in business models and revenue generation timelines. Consequently, comparing P/E ratios is most meaningful when focusing on companies within the same sector, providing a more relevant comparison.
For instance, comparing the P/E ratio of a retail company to that of an oil and gas drilling company might lead to misleading conclusions about their relative investment potential. A high P/E ratio for a particular company might be less concerning if the entire sector exhibits high P/E ratios. Therefore, it’s crucial to consider industry-specific factors and avoid drawing simplistic conclusions based solely on P/E comparisons across diverse sectors.
Other P/E considerations
It’s important to consider additional factors when analyzing P/E ratios. A company’s debt level can influence its share price and earnings, potentially skewing the P/E ratio. For instance, two similar companies with varying debt levels might exhibit different P/E values. The company with more debt might have a lower P/E ratio, but it could also generate higher earnings due to increased risk-taking if its business is fundamentally sound.
Another significant factor to be mindful of is the accuracy of the data used in the P/E ratio calculation. While the market determines share prices, the company provides earnings information, leaving room for potential manipulation. Analysts and investors rely on the integrity of company officers to present accurate financial data. Any breach of trust can negatively impact the stock’s perceived value and increase its perceived risk.
To mitigate these risks, analysts consider a range of metrics beyond the P/E ratio. It’s challenging for a company to consistently manipulate all financial metrics, so a comprehensive analysis helps ensure a more accurate assessment of its financial health and potential. Despite its limitations, the P/E ratio remains a valuable tool in evaluating public companies, but it should not be the sole determinant of investment decisions.
What is a good price-to-earnings ratio?
There is no universal answer to a “good” price-to-earnings (P/E) ratio. The ideal P/E ratio can vary significantly depending on a company’s industry. Some sectors naturally exhibit higher average P/E ratios than others. For example, in February 2024, the technology sector had a considerably higher average P/E ratio than the communications services sector.
To gauge whether a specific P/E ratio is relatively high or low, it’s essential to compare it to relevant benchmarks. These benchmarks include the average P/E ratios of other companies within the same industry, the average P/E ratios of companies in different sectors, and the overall market P/E ratio. By conducting this comparative analysis, investors can gain a better understanding of whether a stock might be overvalued, undervalued, or fairly priced.
Is it better to have a higher or lower P/E ratio?
The question of whether a higher or lower P/E ratio is better depends on various factors and requires a nuanced understanding. While it’s tempting to assume that a lower P/E ratio always represents a better deal due to a lower price per dollar of earnings, this may not always be the case.
A low P/E ratio could indeed signify that a stock is undervalued, offering a potential buying opportunity for investors seeking value. However, it’s crucial to investigate the reasons behind a company’s P/E ratio. If a low P/E is primarily due to a declining business model or other fundamental issues, the perceived bargain might be misleading.
Investors should consider a company’s growth prospects, financial health, competitive landscape, and industry trends alongside the P/E ratio. A comprehensive analysis of these factors is essential for making informed investment decisions. A high P/E ratio might be justified for a company with robust growth prospects and strong fundamentals, while a low P/E ratio could signal underlying problems in a company with a deteriorating business model.
What does a P/E ratio of 15 mean?
A P/E ratio of 15 indicates that the current market value of a company is 15 times its annual earnings. In simpler terms, if an investor were to hypothetically purchase all of the company’s shares, it would take 15 years to recoup their initial investment through the company’s profits.
However, it’s important to remember that this is a simplified illustration. The time it takes to recoup the investment can vary significantly depending on various factors. If the company experiences growth or its earnings fluctuate, the timeframe for recovering the investment will change accordingly.
The bottom line
The price-to-earnings (P/E) ratio is a fundamental tool in financial analysis, offering insights into how the market values a company’s stock relative to its earnings per share. It reflects investor expectations and can help identify whether a stock might be overvalued or undervalued.
The P/E ratio proves particularly useful when comparing companies within the same industry. For instance, it allows for a meaningful comparison between insurance companies or telecom companies, providing a standardized way to assess their relative valuations. This comparison can be valuable in understanding market sentiment and identifying potential investment opportunities.
However, it’s important to note that the P/E ratio is just one piece of the puzzle. It doesn’t account for a company’s future growth prospects, debt levels, or other industry-specific factors that can significantly impact its value. Therefore, investors should always consider the P/E ratio in conjunction with other financial measures to comprehensively understand a company’s financial health and investment potential.