Understanding P/E Ratios (2024)

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• The price-to-earnings ratio (P/E) ratio measures a company's stock price in relation to its earnings per share.
• A low P/E ratio can indicate that a stock is undervalued, while a high P/E ratio can indicate that a stock is overvalued.
• A company's P/E ratio provides insight when compared with others in the same industry, or its sector overall.

When picking stocks, everyone always wants to get a good deal — companies that not only are worthwhile but are trading at a decent price. One time-honored tool for assessing the value of a stock is the price-to-earnings (P/E) ratio.

The P/E ratio is a measure that allows investors to analyze the trading price of a stock and to compare it with others. It can help you determine if a stock's market price is fair relative to the profits the company produces. As a result, it can be helpful to know the ins and outs of calculating the P/E ratio for stock analysis.

What is the P/E ratio?

Definition and formula for calculating P/E ratio

Expressed as a single number, the price-to-earnings (P/E) ratio measures a company's stock price in relation to its earnings per share (EPS).

The P/E ratio is usually indicated along with its price and other key metrics on most online services that provide stock quotes. Here's the formula used to calculate it:

How the P/E ratio works

Interpreting the P/E ratio values

The P/E ratio tells an investor how much hypothetically they are paying for $1 of a company's profits. So, for example, if the share price of a company is $50 and its EPS is $5, the P/E ratio would be 10. In effect, an investor would be willing to pay $10 for $1 of a company's earnings if they purchased the stock.

Now, if another company in the same industry also has a share price of $50 but an EPS of $20, its P/E ratio would be 2.5, meaning it would cost $2.50 to purchase $1 of that company's earnings. The second company is the better value, in theory, if all other variables are equal.

Types of P/E ratios

Trailing P/E vs. Forward P/E

There are two main ways to look at a company's P/E ratio. One is based on historical, or trailing, earnings. This is called the trailing P/E ratio. The other uses a company's projected earnings, based on analysts' estimates, to determine its P/E ratio. This is often referred to as its forward P/E ratio.

While both measure a company's share price relative to its profits, it's important to note that they can sometimes tell different stories. For example, a stock with a relatively high 12-month trailing P/E ratio could lead you to believe that the shares are overvalued. However, if the stock's 12-month forward P/E ratio is lower, it may mean that analysts have been expecting increasing profitability.

Considering both types of P/E ratios will give you a fuller picture of a stock's valuation.

Significance of the P/E ratio

What a high or low P/E ratio indicates about a stock

The P/E ratio is a large component of value investing, a strategy that seeks out companies whose stocks appear to be trading below their fundamental worth.

In general, a low P/E ratio can indicate that a stock is undervalued or that it is performing well, while a high P/E ratio can indicate that a stock is overvalued or that investors expect its performance to improve in the future.

The P/E ratio can be used to evaluate a company on its own, in comparison to other companies, or to a benchmark.

For example, if an investor is deciding between investing in a single stock or an exchange-traded fund that tracks the S&P 500, an investor can weigh the P/E ratios of both the company and the S&P 500 itself to see which is a better value.

Using the P/E ratio in investment decisions

Comparing P/E ratios within industries

So what's a high and low P/E ratio? There's no simple answer. It all depends on the type of company you're dealing with.

When using the aforementioned metric to evaluate stocks, it is crucial to perform P/E ratio comparison within sectors.

That's because each sector and industry will have its own P/E ratio, which will be the average of the P/E ratios of the companies in that specific sector or industry.

There can be significant differences in average P/E ratios between sectors. For instance, you might find P/E ratios as high as 30 in health care and as low as 10 in financial services.

The reason for the disparity is that different industries have unique characteristics. For example, the capital expenditures of an airline company are higher than that of a technology firm and so it will have completely different debt levels and profits, and therefore P/E ratios.

So, the P/E ratio really only provides insight when it is compared with other companies in the same industry — or to the average of the sector overall.

"Every industry is going to have its own best ratios," says Evan Fisher, CEO at Unicorn Business Plans, which creates corporate models and plans.

That being said, "for certain industries, the P/E ratio applies much more as a relevant metric than for others," Fisher adds. "Retail, consumer, manufacturing — things of that nature. Versus younger, high-growth industries —for example, tech — where it may not be so relevant" because the firms have yet to post significant earnings.

Limitations and considerations when using P/E ratio

Investors can benefit significantly from knowing the limitations of P/E ratio in evaluating stocks. Further, there are other considerations that can prove quite helpful to their analysis.

For starters, potential investors should not rely on a single metric when evaluating a company's stock, as no individual metric can tell you whether a company's shares represent a prudent investment.

Another major consideration is that P/E multiples can vary quite a bit between sectors, making the metric more useful for comparing companies within a specific industry.

Past that, the P/E ratio is not particularly helpful in evaluating companies that have not yet turned a profit.

Further, companies report earnings, whereas the price of a stock is determined by the market. Obviously enough, earnings figures can be fabricated, so interested parties should not rely on P/E data alone.

The bottom line

A P/E ratio gives you insight into the current price of a stock: whether that stock is over or undervalued in relation to its peers and also to its own historical price. Focusing on fundamentals — a company's earnings per share — it blocks out external noise, like a market bubble that's pushing prices inordinately high, or panicky sell-offs, which could push them lower.

The P/E ratio is only one source of information and it should be used to aid an analysis rather than as a sole point of data to rely on.

"It's not something we ever look at in isolation," Fisher says. "I would take the P/E ratio as one of the facets of the diamond that is the company. But you have to look at all the other facets as well, things like management effectiveness, future earnings forecasts, existing assets, positioning versus competitors, customer satisfaction."

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