P/E Ratio: Price-to-Earnings Complete Guide

Definition & Explanation | Formula & Examples | Good v. Bad | High v. Low | Analysis & Interpretation

Emilie N.- FCCA, CB, MBS
Emilie N.- FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from corporates, financial services firms - and fast growing start-ups.

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Definition: What Is P/E Ratio?

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?
Financial Indicator Meaning
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:

  • Price/Earnings or Price-Earnings or Price Earnings
  • Price-to-Earnings
  • PE or P/E Ratio
  • PER
  • Earnings Multiple, Price Multiple, Multiple

These terms are used interchangeably within this article.

Importance: Why Does P/E Ratio Matter?

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:

  1. Markets are overvaluing or undervaluing stock
  2. Stock is being traded on a speculative or investment basis

Use: How Do You Use P/E Ratio?

The Price/Earning analysis can be based on a variety of factors, including:

  • Company’s own historical performance record and future projections
  • Aggregate industry, index and other benchmarks
  • Future direction of the stock in the context of investor perception of a company’s performance, earning power, growth rate and risk profile

Keep reading to find out how to calculate, interpret and use the P/E ratio to your advantage and make smart investment decisions.

Explanation: What Does P/E Ratio Mean?

As an example, if shares of a company that reports earnings per share (EPS) of $1 trade at $10, then the P/E ratio is 10 (= $10 share price divided by $1 EPS).

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.

  • This is why the P/E is sometimes referred to as the “price multiple”.

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).

  • This is why the P/E is sometimes referred to as the “earnings multiple”.

Formula: How to Calculate P/E Ratio?

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.

Alternative P/E Ratio Calculation Formulas

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:

  • Realized earnings (Trailing P/E)
  • Projected earnings (Forward P/E; with or without discounting)
  • Combination of realized-trailing and projected-forward earnings (e.g., sum of the last 2 actual quarters and the estimates for the next 2 quarters)
  • Corrected” earnings that exclude certain significant one-off gains or losses (e.g., a sale of a subsidiary that could inflate earnings in the short term.)
  • Average earnings over a period of time (e.g. help to “smooth” volatile or cyclical earnings over time)

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.

Trailing P/E Ratio

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:

  • Past performance is of limited use when predicting future behaviour and earnings potential, which is what investors are mostly interested in.
  • Companies only release earnings reports periodically (e.g., quarterly), whereas stocks trade constantly. Hence, the EPS figure remains constant, while the stock prices fluctuate. As a result, the trailing P/E does change as the share price moves, but it does not reflect the stock market changes adequately.

In the light of these shortcomings, some investors prefer to analyze the Forward P/E >>

Forward P/E Ratio

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:

  1. Estimating future earnings
  2. Comparing current and future earnings

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.

Absolute vs. Relative P/E Ratio

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.

Example: Two P/E Ratio Calculation Examples

Price/Earnings Example #1

Question:

Both Company A and Company B are trading at $100 per share. However, Company A reports earnings of $10 per share (EPS), whereas the EPS of Company B is $20.

What does this mean?

Answer:

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 10 5
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:

  • other financial metrics
  • non-financial criteria
  • comparison against industry, index and other benchmarks
  • investor preferences (e.g., value vs. growth, risk appetite)

 

Price/Earnings Example #12

Question:

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.

Answer:

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.

Good/Bad: What is a Good P/E Ratio?

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 >>>

High/Low: Is it Better to Have a High or Low P/E Ratio?

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.

Investors are willing to pay more for shares in financially-sound, well-established and relatively low-risk companies with strong historical performance, expected future earnings growth and return on investment–which translates into higher Price/Earnings multiples.

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
Company Valuation Overvalued Undervalued

High P/E Ratio: Pros & Cons

Pros of High PER

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.

Cons of High PER

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 P/E Ratio: Pros & Cons​

Pros of Low PER

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.

Cons of Low PER

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 >>>

Analysis: How to Interpret P/E Ratio?

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:

 1. Earnings-per-share (EPS):

  • Market’s perception of historic level of earnings
  • Market’s expectations of future earnings performance

 2. Share price, which is an expression of market’s consensus regarding:

  • Company performance and prospects in terms of growth, risk and gearing (= debt, leverage)
  • Microeconomic and macroeconomic factors
  • Comparability with industry benchmarks

Let’s take a closer look at each of these factors affecting the price-to-earnings ratio >>>

P/E Analysis: Internal Considerations

The key internal factors that affect the P/E ratio include:

  1. Earnings
  2. Gearing
  3. Trend analysis

1. Earnings

Comparability

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:

  • Inconsistent accounting policies (e.g., definition and treatment of earnings and the factors that impact them)
  • Different timelines during which companies generate revenues
  • Average benchmarks (e.g., growth rates, debt levels) vary significantly between industries, business models, regions etc.
  • Possibility of the financials being manipulated (e.g., inflated earnings)
EPS

Since the P/E ratio measures the relationship between the market price and earnings of a share, a rise/fall in EPS may cause a rise/fall in the price-to-earnings ratio.

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:

  1. The P/E ratio tends to change gradually.
  2. When the EPS goes up or down, the share price should be expected to move up or down also.

Consequently, the new share price will be the new EPS multiplied by the constant P/E ratio.

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
EPS 50c 70c
Share Price $5.00 10 x 70c = $7.00
P/E Ratio 10 10
No Earnings

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:

  • N/A (stands for “not available”)
    • The most common convention because the PER is not really available / interpretable / comparable until a company becomes profitable.
  • 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.

  • Negative (<0)
    • While it is possible to calculate a negative PER for companies that are losing money, this convention is not commonly used.

2. Debt

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:

  • High level of gearing means that a company carries a high ratio of debt to equity, which can lead to more variable earnings being available to equity holders.
  • Consequently, shareholders of a highly geared company take on a higher level of risk compared to an investment in a low-geared company.
  • As a result, the EPS–and in turn the P/E ratio–may fall because of the increased gearing.

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.

3. Trends

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:

  • Comparison of past P/E ratios of the same company, looking for trends in historic data of one entity that can help gauge the future direction of the stock and whether the price is relatively high or low compared to the past.
  • P/E 10-30 metrics that are used by analysts interested in long term trends to value a stock index (e.g., S&P 500) over the past 10-30 years.

In addition to previous trends, the current P/E ratio should be evaluated in conjunction with:

  • Forward-looking projections
  • Broader company performance and outlook

P/E Analysis: External Considerations

Moreover, the P/E ratio is significantly influenced by the external environment of a company, including the following factors: 

  • Peers (e.g., the same industry, region, size, maturity or business model), which could include:
    • individual companies and competitors
    • stock market indexes
    • aggregate industry averages
    • other benchmarks
  • Wider market (e.g., economic cycle, regulation)

Industry

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.

PESTLE

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:

  • Political
  • Economical
  • Societal
  • Technological
  • Legal
  • Environmental

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.

Context is King

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.

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Emilie N., FCCA, CB, MBS
Emilie N., FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from large corporates and banks, as well as fast-growing start-ups.

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