Price-to-Earnings (P/E) Ratio
What Is a Price-to-Earnings Ratio? P/E Explained
A P/E (price-to-earnings) ratio is a simple however popular metric used by investors and institutions to determine the relative value of a company's stock.
Here, "price" means current price per share of a stock, and "earnings" means a company's profit per share over a specific period of time (generally a year).
In other words, a company's P/E ratio is how much investors pay per dollar of annual company earnings. Assuming a company's P/E ratio is 10, that means its shares cost 10 times the profit it makes on a per-share basis in a year.
Instructions to Calculate a P/E Ratio
To calculate a company's P/E ratio, divide the price of one share of that company's stock by the [earnings per share](/fundamental earnings-per-share) (often abbreviated EPS) of that company's stock over a period of 12 months.
A company's P/E ratio is typically expressed in terms of x, which simply means "times." For instance, a P/E ratio of 5x means that a company's stock price is five times its annual earnings per share.
Price-to-Earnings Ratio Formula
P/E = Share Price/Earnings per Share
Alternatively, P/E can be calculated by separating market capitalization (instead of share price) by total annual earnings (instead of earnings per share). Market capitalization is the total value of all outstanding shares of a company's stock.
P/E Ratio Example
Thus, on the off chance that an imaginary company called Acme Adhesives currently trades at $100 per share, and the company earns $25 of profit per share of stock over 12 months, then Acme's P/E ratio is 100/25, or 4x. This means that Acme's stock price is four times its annual earnings per share.
Another method for conceptualizing a company's P/E ratio is to think of it as the price investors pay for $1 of company earnings per year. Utilizing the example above, a new investor could expect Acme to earn $1 per year for every $4 they invest.
Why Are P/E Ratios Useful?
Since every stock has a different price, a different number of shares in circulation, and different earnings, seeing them in terms of their P/E ratios makes them more easily comparable. In other words, the P/E ratio fills in as kind of a common language through which to evaluate stocks that could otherwise be challenging to compare.
By taking a gander at the P/E ratios of different companies across an industry — all of which have a different number of shares, a different market price, and different earnings — an investor could possibly get a better idea of which companies have recently provided higher returns to their investors.
That being said, P/E ratios are in no way, shape or form the primary indicator of whether a stock will perform well over time. The market is extremely complex, and nobody metric rules them all. P/E ratios simply provide one of numerous useful tools that an intelligent investor can incorporate into their toolkit as they attempt to evaluate stocks and refine their investment strategy.
What Are P/E Ratios Used For?
P/E ratios are used to understand the value or worth of a company's stock compared to other, comparative stocks or to the market as a whole as estimated by stock indexes like the S&P 500. P/E ratios can likewise be used to compare a stock's current value to its past value or projected future value.
One investor could compare the P/E ratios of multiple companies in a particular industry or sector that they're interested in to determine which one has the lowest ratio and therefore may be the most undervalued. Another investor could compare the P/E ratio of a stock they're considering buying to that of their preferred index to try to gauge its value relative to the market as a whole. An investor interested in short selling could search for companies with high P/E ratios yet whose fundamentals don't seem particularly strong and bet on their prices going down over time.
It's important to keep as a top priority that different companies make money in different ways and at different rates, so the more comparative two companies are, the more knowledge their P/E ratios are likely to provide when compared. For instance, a technology company and a transportation company are unlike such an extent that comparing their P/E ratios alone probably isn't the best strategy for determining which company is a better buy.
What Are the 3 Types of P/E Ratios?
While all P/E ratios represent a stock's price divided by its year earnings, there are three different types of P/E ratios, and each is calculated based on a different period of earnings.
1. Trailing Price-to-Earnings
Trailing P/E ratios divide the current share price by the most recently available 12 months of earnings per share. (Earnings per share are typically reported quarterly.)
Past earnings, insofar as they are honestly reported, are not disputable because they've already occurred. Therefore, trailing P/E ratios are popular with investors who prefer not to rely on companies' projections about their future earnings.
While trailing P/E ratios offer the most objectivity, they really do have downsides. For one's purposes, past performance isn't necessarily predictive of future success. Second, stock prices fluctuate daily, however trailing earnings per share can normally just be updated quarterly (when they are released), so trailing P/E ratios can change rapidly with stock price and become more obsolete the longer it's been since the latest quarterly earnings were released.
Instructions to Calculate a Trailing P/E Ratio
Acme earned $5 per share of stock over the last 12 months, and the current share price is $105.
Trailing P/E = current price per share/earnings per share over past 12 months
Trailing P/E = $105/$5Trailing P/E = 21x
2. Forward (AKA Leading or Estimated) Price-to-Earnings
Forward P/E ratios divide the current share price by future EPS as estimated by a company's earnings guidance. This can be helpful to investors in that it can give them an idea with regards to how future earnings could compare to current quarter earnings and past earnings. In other words, it is often used related to the trailing P/E ratio to identify longer-term trends and make predictions.
While useful for analysis, predictions, and trend-mapping, forward P/E ratios are inherently subjective and entirely predictive since they rely on earnings that have yet to happen and are estimated internally rather than by an outsider. Purposeful or accidental over or underestimations of future earnings can happen.
Step by step instructions to Calculate a Forward P/E Ratio
Acme predicts that it will earn $7 per share over the next 12 months, and the current share price is $105.
Forward P/E = current price per share/projected earnings per share over next 12 months
Forward P/E = $105/$7Forward P/E = 15x
3. Hybrid (AKA Current) Price-to-Earnings
Rather than using solely past earnings or projected future earnings, hybrid P/E ratios use both. Hybrid P/E ratios are calculated by isolating the current share price by the sum of the previous two quarters' genuine earnings and the projected earnings for the next two quarters. Along these lines, the denominator in the equation comprises of six months of real, past data, and six months of projected future data.
Since hybrid P/E ratios combine elements of both trailing and forward ratios, some investors think they strike a healthy balance between accurate yet potentially outdated data and subjectively predicted estimations about future earnings.
Step by step instructions to Calculate a Hybrid P/E Ratio
Acme's earned $2.50 per share over the last 12 months and the company projects that it will earn $3.50 per share over the next 6 months. The current share price is $105.
Hybrid P/E = current price per share/(half year trailing EPS + half year projected EPS
Hybrid P/E = $105/($2.50 + $3.50)Hybrid P/E = $105/6
Hybrid P/E = 17.5x
What Do High and Low P/E Ratios Mean?
A high P/E ratio indicates one of two things — either a company's stock is overvalued by the market, or the market expects it to perform well in the future. A low P/E ratio likewise indicates one of two things — either a company's stock is undervalued by the market, or the market expects it to perform poorly in the future.
For some random P/E ratio, different analysts could offer different explanations. One analyst could take a high ratio (along with other relevant data) to mean that a company is overvalued, while another could interpret the same metric (along with other relevant data) to mean the company is slated for success.
The true meaning of a high or low P/E ratio is in the eye of the beholder. Analysts' views often differ because they place different measures of significance on different factors in different circumstances. Each investor must decide for themself how to interpret P/E ratios and other metrics when evaluating stocks as indicated by their own strategy or ruleset.
Highlights
- A P/E ratio holds the most value to an analyst when compared against comparative companies in the same industry or for a single company across a period of time.
- Companies that have no earnings or that are losing money don't have a P/E ratio because there isn't anything to put in the denominator.
- The price-to-earnings (P/E) ratio relates a company's share price to its earnings per share.
- Two sorts of P/E ratios — forward and trailing P/E — are used in practice.
- A high P/E ratio could mean that a company's stock is overvalued, or that investors are expecting high growth rates from here on out.
FAQ
Is a Lower P/E Ratio Better Than a Higher One?
While it is actually the case that lower P/E ratios translate to higher earnings (during the period in question), stocks with lower P/E ratios are not generally better investments than stocks with higher ones. As mentioned above, average P/E ratios change fiercely between industries, and older, more established companies tend to have lower ratios than newer, up-and-coming companies that are in growth phases and have high costs. Stocks with low forward P/E ratios may not necessarily perform as well as projected. Depending on a singular's investment strategy, low P/E ratios might be important indicators when it comes to picking stocks successfully.
What Is a Good P/E Ratio?
There is no best P/E ratio, and average P/E ratios fluctuate across industries. It's important to remember that a company can have a high P/E ratio because it is overvalued, yet it can likewise have a high ratio because investors as well as analysts think it has major future earnings potential. Older companies that have had consistently low P/E ratios over long periods of time might appeal to risk-averse investors seeking modest however consistent returns. Newer companies with low or non-existent P/E ratios that are experiencing growth might appeal to investors with higher risk tolerance who are seeking larger returns.
What Is an Average or "Typical" P/E Ratio?
As mentioned above, average P/E ratios shift quite a ton between industries, so there is really no "typical" ratio. That is one of many reasons why context is so important when considering this metric. Furthermore, a company's age ought to be taken into consideration when evaluating its P/E ratio. Well-established companies that have been around for quite a while may have lower P/E ratios than newer companies in the same industry. NYU keeps a page that rundowns average P/E ratios by industry.
Might a Stock at any point Have a Negative P/E Ratio (or a Ratio of 0)?
Since 0 can't serve as the denominator in any division, a company can't have a P/E ratio of zero. A negative P/E ratio would indicate a loss (instead of earnings) over the year period in question. Much of the time, however, companies that experience losses don't report a negative P/E ratio; instead, they might list their earnings as "N/A" (not applicable). Negative earnings are normal, especially in newer companies that are focused on growth and capturing market share. A consistently negative P/E ratio over a long period of time, however, could indicate that a company is headed toward bankruptcy.
