Definition & Explanation | Formula & Examples | Good v. Bad | High v. Low | Analysis & Interpretation
The Price-to-Earnings (P/E, PER) ratio is one of the most widely used stock analysis metrics because it quickly and easily measures the relationship between the market value and earnings capacity of an entity, which are both key investor considerations.
|Price-to-Earnings: What Does P/E Ratio Mean?|
|Share Price||Price investors are willing to pay for stock ownership per unit of a company’s earnings, reflecting market expectations of value, growth and risk.|
|Earnings||Financial performance of a company now and into the future.|
|Price / Earnings Ratio||How investors perceive stock valuation: Undervalued / Overvalued / Accurate|
In isolation, the earnings and share price alone tell you how a company is performing and how much investors are willing to pay to own its stock, respectively.
However, combined together in the Price/Earnings ratio, they tell you how investors perceive the company’s performance and whether the share price accurately reflects the company’s value and earnings potential in the eyes of investors.
Investors and analysts then compare their own perception of the risk and growth of stocks against the market’s collective perception as reflected in the Price-Earnings ratio in order to buy or sell accordingly.
The ratio is commonly referred to by a number of different names, including:
These terms are used interchangeably within this article.
Investors and analysts use the P/E ratio to compare individual stocks or entire stock indexes (e.g., S&P 500) against one another and over time in order to determine whether the stock valuation is relatively high or low to support their investment decisions.
Therefore, the P/E ratio enables you to understand whether:
The Price/Earning analysis can be based on a variety of factors, including:
Keep reading to find out how to calculate, interpret and use the P/E ratio to your advantage and make smart investment decisions.
But…What does a P/E ratio of 10 mean exactly?
Price-Earnings ratio of 10 (10:1) shows that investors are currently willing to pay $10 in share price for every $1 of earnings per share generated by a company.
In addition, the ratio can also be interpreted as the amount of time (typically years) over which the company would need to sustain its current earnings to pay back the current share price.
In other words, a P/E ratio of 10 means that the current market value of the company is equal to 10 times its current earnings. Hence, if earnings stayed constant, it would take 10 years to recoup (for the investor) and repay (for the company) the investment cost (= share price).
There are 3 formulas to calculate the Price-to-Earnings (P/E) ratio:
|Price/Earnings Ratio: 3 Calculation Formulas|
|1. Universal||P/E = Market Value ÷ Earnings|
|2. Individual Shares||P/E = Price per Share ÷ Earnings per Share (EPS)|
|3. Total Company Equity||P/E = Total Market Value ÷ Total Earnings|
Sometimes you see the P/E ratio calculated as:
Market Capitalization ÷ Net Income.
This formula often gives the same answer as Market Price ÷ Earnings, but not always, especially if new capital has been issued.
In practice, many different variants of the standard price-to-earnings ratio calculation are common.
For example, although the P/E ratio is usually calculated using the current share price, you can use an average price over a certain period of time.
When it comes to the earnings part of the calculation, there are multiple alternative approaches to the P/E ratio that substitute different measures of earnings, including:
A well-known example of the last approach is the Shiller P/E ratio, or CAP/E (cyclically adjusted price earnings), used to value the S&P 500 index, which is calculated by dividing the share price by the average inflation-adjusted earnings over the past 10 years.
Nevertheless, the Trailing calculation is the most common meaning of the P/E ratio, especially in the absence of any specifications.
Using actual past financials reported by a company, as opposed to someone’s earnings estimates, makes this P/E metric more objective.
Consequently, this is arguably the most popular method to determine the P/E ratio, widely used in the investment community, including Google Finance and Yahoo! Finance websites and apps like Robinhood.
Nevertheless, the trailing P/E also has its disadvantages:
In the light of these shortcomings, some investors prefer to analyze the Forward P/E >>
The forward P/E ratio benefits from using the available information of how the market expects a company to perform in the future, such as the projected net earnings over next 12 months.
Therefore, this forward-looking indicator is useful for:
If the forward P/E ratio is lower than the trailing P/E ratio, it indicates that analysts expect a company’s earnings to increase. On the other hand, when the forward P/E is higher than the current P/E ratio, analysts expect a decrease in income.
|Forward vs. Trailing Price-to-Earnings Ratio|
|P/E Ratio||Earnings Expectations|
|Forward < Trailing||Increase|
|Forward > Trailing||Decrease|
The inherent limitation of the forward P/E ratio is that the metric is based on the opinions of the person making the predictions and so earnings may be under/over-estimated, whether on purpose or not.
Hence, forward Price/Earnings analysis useful, but prone to inaccuracies.
If the current or absolute P/E ratio is lower than the past or benchmark P/E value, the relative P/E has a value below 100%–and vice versa.
|Absolute vs. Relative Price-to-Earnings Ratio|
|Absolute P/E Ratio||Relative P/E Value||Explanation|
|Current < Past||<100%||Current/absolute P/E ratio is lower than the past/benchmark value.|
|Current > Past||>100%||Current/absolute P/E ratio has surpassed the past/benchmark value.|
Company A has a Price/Earnings ratio (PER) of 10, while Company B has a PER of 5.
|Calculation of Price/Earnings Ratio (PER) – Example #1|
|Company Financials||Company A||Company B|
|Share price per share||$100||$100|
|Earnings per share (EPS)||$10||$20|
|PER = Share Price ÷ Earnings||$100 ÷ $10 = 10||$100 ÷ $20 = 5|
Even though Company A and Company B are both trading at $100 per share, Company B is actually cheaper (PER = $5) compared to Company A (PER = $10), because Company B has a lower PER than Company A.
In addition to being less expensive, Company B has double the earning power of Company A. This is because for every share of stock purchased in Company A, an investor gets $10 of the company’s earnings–as opposed to twice as much ($20) in earnings per share received from Company B.
In other words, as Company B is trading at 5 times its earnings, it would need 5 years of current earnings to reimburse its shareholders for their investment cost (= share price). In contrast, Company A would need twice as long–10 years–to repay its investors.
|Calculation of Price/Earnings Ratio (PER) – Example #1|
|PER Interpretation||Company A||Company B|
|PER Explanation||More expensive with lower earning power||Less expensive with higher earning power|
|Price multiple||Investors pay $10 in share price for every $1 of earnings||Investors pay $5 in share price for every $1 of earnings|
|Earnings multiple||10x (it would take 10 years of current earnings to pay back the share price)||5x (it would take 5 years of current earnings to pay back the share price)|
|Earning power||0.10c in earnings received per $1 of share price paid||0.20c of earnings received per $1 of share price paid|
Consequently, based on the Price-Earnings ratio analysis alone–everything being equal–it would be a no-brainer to invest into Company B that is cheaper with higher EPS.
However, in reality the decision to buy/hold/sell shares in Company A and/or Company B would be much more complex, including (but not limited to) the evaluation of:
Company A and Company B have both reported earnings per share (EPS) of $5.
The stock of Company A is priced at $75, while shares of Company B can be purchased for $25.
The companies are in the same industry with an average Price/Earnings Ratio (PER) of $10.
|Calculation of Price/Earnings Ratio (PER) – Example #2|
|Company Financials||Company A||Company B|
|Share price per share||$75||$25|
|Earnings per share (EPS)||$5||$1|
|Industry Average PER||20||20|
|PER = Share Price ÷ Earnings||$75 ÷ $5 = 15||$25 ÷ $1 = 25|
Despite having a significantly (3x) higher absolute price per share ($75 vs. $25), Company A is in fact cheaper in terms of PER than Company B because investors need to pay less ($15 vs. $25) for every 1$ of current earnings.
However, as Company B has a higher PER than both its competitor Company A and the industry on average, investors will likely expect higher earnings growth in the future relative to the competition.
Again, the P/E ratio is just one of the many metrics and tools available to guide one through investment decisions and so should not be used in isolation.
Since there are no hard-and-fast rules for what makes a good P/E ratio, the better question to ask is:
What is better – high or low Price / Earnings?
Let’s answer this million dollar question (sometimes literally) right now >>>
Essentially, you could think of the P/E ratio as a “price tag” used as a guide to determine whether a stock is an undervalued bargain or an overvalued premium item–or anywhere in between on the spectrum.
The higher the P/E ratio, the more expensive a stock is relative to its earnings–and vice versa.
As a result, the P/E ratio depends on the collective market perception, expectations and confidence in the future prospects of a company.
|Price Earnings vs. Market Expectations|
|Company Indicators||High P/E Ratio||Low P/E Ratio|
|Earnings: Historical Performance||High||Low|
|Earnings: Future Growth Prospects||High||Low|
High Price-to-Earnings suggests positive future performance, because companies with higher ratios are typically “growth” stocks, meaning that investors have higher expectations for future earnings growth potential–for which they are willing to pay a higher share price today.
In addition to higher growth expectations, one company could have higher PER than another because investors believe that it is less risky (e.g., more stable business model or industry; lower gearing), leading to the company’s earnings being subject to less risk and uncertainty.
The downside of high Price-to-Earnings is that it could mean that the share price is high relative to earnings of the company and possibly overvalued.
In reality, it is difficult–if not impossible–to objectively determine if a high P/E ratio is the result of high expected earnings growth or if the stock is simply overvalued.
Moreover, some high-PER growth stocks may be considered a higher risk investment, because of the higher levels of uncertainty and volatility inherently associated with fast growth.
Also, it is important to note that not all companies with high Price/Earnings are expected to perform to a high standard. A high P/E ratio only means that a company is expected to do significantly better than in the past. Therefore, high-PE companies may simply have greater growth potential because they are being compared to a low base.
Low Price-to-Earnings may indicate that a stock is undervalued, because it trades at a price that is low relative to a company’s earnings.
Companies with low P/E ratio are often called “value” stocks as investors buy them hoping to take advantage of this mis-pricing by making a bargain and selling at a profit when the market corrects itself to a higher share price that better reflects the true value of the company.
Moreover, low P/E stocks can be found in established companies and mature industries that pay out dependable and steady dividends.
The downside of low Price-to-Earnings is that it could mean lower investor confidence in the company and its future performance, where growth is expected to be slow or non-existent.
As a result, it is vital to understand the reasons behind a company’s low P/E ratio, because a bargain could turn out to be a nightmare investment into a company that is fundamentally flawed and going into a permanent state of decline.
Keep reading to find out how to do just that >>>
Since the P/E ratio measures the relationship between the market value and earnings, the metric changes over time based on the factors that affect these two variables, including:
2. Share price, which is an expression of market’s consensus regarding:
Let’s take a closer look at each of these factors affecting the price-to-earnings ratio >>>
The key internal factors that affect the P/E ratio include:
One of the key limitations of using Price/Earnings to compare different companies is that the source of earnings information is the companies themselves, resulting in:
However, the changes in earnings do not typically affect the P/E ratio to the same extent as changes in share price. This is because the following is generally true:
In fact, this is called the “P/E ratio approach”, which is often used to estimate share prices of companies.
For example, suppose the P/E ratio of Company A was 10 last year, because it had an EPS of 50c and a share price of $5.00. In the current year, the EPS is 70c. Everything else being equal, we can expect for the P/E ratio to remain the same (= 10). So, the share price should go up to 10 x 70c = $7.00 this year.
|P/E Ratio Approach: Example|
|Company Financials||Previous Year||Current Year|
|Share Price||$5.00||10 x 70c = $7.00|
Opinions vary on how to calculate and label the Price/Earnings ratio (PER) for companies that have no earnings (no profit) or operate at a loss (negative earnings), including:
Nil (expressed as “0” or “Nil”)
This convention is used especially for companies that do not generate profit because there is essentially nothing to put into the PER formula denominator.
The level of debt in a company has an influence on the P/E ratio because it affects both earnings and share price.
In general, a higher P/E ratio is more likely to be found in a company with lower gearing (= less debt) than in one with higher gearing (= more debt) because:
However, if the share price does not fall as much as the earnings, it indicates that the market views the projects that the increased gearing is intended to fund in a positive light.
Furthermore, if business is going well, the company with more debt is likely to generate more earnings because of the risk it has taken on, possibly resulting in a higher share price and P/E ratio.
Nevertheless, on average the share prices of highly-geared companies tend to be lower than those of low-geared entities.
Interestingly, however, companies with low P/E ratios may be more open to leveraging their balance sheet because it lowers the P/E ratio and drives up the share price by making the company look cheaper and improving the earnings growth rates.
Price/Earnings trend analysis should be done over time because a single year’s P/E ratio may not form a sufficient basis for decisions, especially if earnings are subject to cyclicality, volatility or any unusual items (e.g., after mergers & acquisitions) for which a longer term analysis can compensate.
Examples of Price/Earnings trend analysis:
In addition to previous trends, the current P/E ratio should be evaluated in conjunction with:
Moreover, the P/E ratio is significantly influenced by the external environment of a company, including the following factors:
The average PE ratios vary wildly from industry to industry.
As a result, the answer to whether a PE ratio is high or low depends on the sector in which a company operates.
For example, mature slow-growth industries like consumer staples, utilities and pharmaceuticals typically carry lower P/E ratios than industries like software and technology where companies typically trade at larger PE multiples as a result of their higher growth prospects, profit margins and returns on equity.
Hence, comparing the PE ratios of a utility company and a software company may lead you to believe that one is clearly the superior investment, however, this is not an accurate assumption to make.
In other words, for the PE ratio to yield valuable insight, always compare apples to apples in the same area of the economy.
Investors’ expectations reflected in the P/E ratio may be affected by a wide variety of external circumstances. For this reason, it is useful to include the following set of factors, sometimes abbreviated as PESTEL, into any Price-Earnings analysis:
For example, when the wider economy is booming, investors are generally more confident in the future earnings potential of companies, causing the Price-Earnings multiples to rise. The opposite is true during an economic recession or whenever the stock markets are not doing as well–investor expectations go down along with the stock prices and P/E ratios.
There never is a one single financial ratio or metric that can tell investors all they need to know about a stock and provide complete insight into an investment decision.
Similarly, although the price-to-earnings ratio is one of the most popular stock valuation ratios, it has many shortcomings and should not be used as a single indicator of a company’s stock value.
Instead, it is vital to combine a variety of different financial and non-financial indicators to arrive at a complete picture of a company’s financial health and its stock valuation.
Sign up for our Newsletter
Get more articles just like this straight into your mailbox.