The price-to-earnings (P/E) ratio is arguably the most common financial ratio used to value a stock. A stock’s P/E ratio tells investors how much they are paying for one dollar of a company’s earnings. In this article we’ll take and in-depth look at the P/E ratio including how it’s calculated, how investors should analyze P/E ratio, and why it’s important. The article will also compare the P/E ratio with some other commonly used financial ratios.
What is the Price/Earnings (P/E) Ratio?
The price-to-earnings ratio is a measurement of how much an investor is paying for one dollar of a company’s earnings. When a company has a P/E ratio of 15 investors are paying $15 for every dollar of a company’s earnings.
Value investors use the P/E ratio to determine whether a stock is overvalued or undervalued. The ratio can also reveal how a stock’s value compares with that of the industry average or a benchmark index for that matter.
The two components of the P/E ratio tell investors a story of price versus value. Stock price (the P in the P/E ratio) tells investors how much it will cost them to buy one share of a company’s stock. Earnings per share (the E in the ratio) gives investors an idea of how valuable those shares are.
How Do You Calculate P/E Ratio?
The two components used to calculate the price to earnings ratio are the stock price, which is set by forces of demand and supply in the market, and EPS, or earnings per share over a specific period of time, usually one year.
Here are a couple of examples using stock prices and EPS values as of June 29, 2022:
Dollar General has a share price of $247.65 and in the last four quarters it has delivered a total EPS of $9.75. Its P/E ratio is calculated as follows:
247.65/9.75 = 25.4
Dollar Tree has a share price of $156.01 and a total EPS of $6.57. Its P/E ratio is calculated as follows:
156.01/6.57 = 23.7
It’s that simple. And while a stock’s P/E ratio is readily available to investors, it’s easy for investors to find the information they need. And the math is just as simple as shown above.
How is Trailing P/E Different From Forward P/E?
The price-to-earnings ratio is calculated using earnings per share of the last four quarters, a metric normally referred to as trailing earnings per share. The most commonly displayed P/E ratio is a trailing P/E ratio that means it is based on the most recent four quarters of earnings. This means that in all but one quarter of the year, the P/E ratio reflects not only earnings that are occurring in the current fiscal year but also those that the company delivered in the prior fiscal year.
This is why some investors choose to use a different metric known as the forward P/E ratio. This comes from the company’s guidance. It’s common for company management to issue earnings forecasts for subsequent quarters. Investors and analysts can use these numbers to calculate a forward P/E ratio. This gives investors an idea of how confident a company is in their profit forecast in the next four quarters.
For investors who are looking to take a long position in a company’s stock, the forward P/E ratio may be more valuable than its current P/E ratio. By contrast, a short-term trader may be more interested in the current P/E ratio because they are looking at how to profit in the short term.
Should Investors Avoid Companies With a Negative P/E Ratio?
P/E is typically only calculated for companies that are profitable (i.e., companies with positive earnings). A company that is losing money would have a negative P/E. Negative P/E values are usually listed as N/A (not available) to avoid confusion.
However, a lack of profitability may not be an obstacle for growth-oriented investors. That depends on where a company is at in its business cycle,
What is a Good P/E Ratio?
Any investor or advisor that says they know the answer to this is not being truthful with you. It’s true that you can look at indexes such as the S&P 500 index or the NASDAQ index for guidance. But since these index funds carry stocks from different sectors, it’s not a one-size-fits-all solution.
With that in mind, some investors will look at the average P/E ratio for a specific sector. For example, they can look at the average P/E ratio for the technology sector and then compare that to a specific company they are considering such as Apple or Microsoft.
However, this also fails to take into account the specifics of an individual company. Within a specific sector, one company may trade at an above-average P/E ratio and be worth the price. Another may have an average or below average P/E ratio and still be overvalued.
How to Analyze P/E Ratio
With that in mind, investors can use some broad principles to analyze a company’s P/E ratio.
First, a stock with a lower P/E ratio relative to the industry average will often be a better value when compared to a stock with a higher P/E. This is because a low P/E ratio allows investors to pay less for every dollar on earnings.
However, it’s also important to note that a lower P/E ratio may be indicative of poor current and predicted performance. While an investor will be able to pay less for every dollar of earnings, if the company continues to underperform the company’s earnings and its stock price may continue to fall.
Second, companies with higher P/E are expected to have higher earnings in the future. If the company pays dividends it is usually expected to issue higher dividends. This expectation of future growth is why investors are willing to pay a premium for the company’s stock.
Why the Price-Earnings Ratio Is Important
Price to earnings ratio is important because it gives clues about key fundamentals of a company such as its future growth prospects, investor confidence, and the amount of risk investors take on at its current price. If a company has a proven track record, then it is more than certain to have a higher P/E, relative to a company with a low P/E.
Companies with robust corporate governance command higher P/E than their peers as good oversight goes a long way in strengthening investor confidence in the stock. High and stable dividend-paying companies also command high P/E in part because it shows fundamental strength in a company’s ability to reward shareholders.
Value investors, who are always looking for bargains in the stock market, will search for stocks that have a low P/E ratio. The lower the metric, the less they have to pay per dollar of earnings. Companies that have a low P/E ratio but are otherwise solid companies can be a good investment because they are currently undervalued but the price is likely to increase in the future.
It is important to look at a company’s P/E in light of industry benchmarks. Industries affected by economic cycles tend to trade at much lower P/E compared to those that aren’t.
What is the Difference Between Price-to-Earnings and Price-to-Book (P/B)?
Price-to-earnings and price-to-book are two commonly used ratios regarding stock value. Price to book ratio is a ratio that compares a company’s market value to book value. Book value refers to the company’s total assets minus total liabilities.
Price to book ratio underscores the value that market participants attach to a company’s equity. Companies command different P/Bs because some companies and industries are more efficient at producing income from their assets than others.
Price to book value differs from price to earnings ratio in the fact that it can be used to value firms with positive book values and negative earnings, i.e., companies that are making losses. P/E is only a useful measure for companies with positive earnings. However, P/B can be useless when used in companies with few tangible assets in their balance sheets, such as information tech companies that mostly offer services. In addition, the metric can remain negative for long periods should a company that has more debt than assets.
Price to Book ratio is ideal for analyzing stocks in industrials as well as in the financial sector. This is in part because these companies have a stronger link between assets and income generating ability. Industrial companies have assets tied to inventory and property, such as production plants or equipment. Property and loans on the other hand account for a huge chunk of assets owned by financial institutions.
The bottom line is that the P/E ratio allows you to consider what premium you are paying for a company’s earnings. It is up to you to decide whether the company’s expected growth warrants the premium at stake. As part of an investor’s due diligence, the P/E ratio should be in combination with other metrics to determine the actual value of a stock prior to investing.
It is also important to note that a company with a high P/E ratio will always be under pressure to live up to market expectations. Investors expect such companies to register continuous earnings growth, and failure to do so always result in a stock price drop. It is for this reason that investors tend to be a little bit cautious when it comes to companies with a high P/E.
Conversely, just because a company has a lower P/E does not mean that its stock is a buy. In this case, it would be wise to do extensive research to determine why the company has a lower P/E before jumping into a trade. Low P/E at times reflects a lack of growth potential which could make it difficult for an investor to generate significant returns in the long term.
That said, the price to earnings ratio is not the only number worth considering when planning to buy shares. Some other things to look out for include dividend rate, price to book ratio, earnings charts as well as sales figures.