The price-to-earnings ratio (P/E) is among the most important and commonly used valuation metrics in the fundamental analysis of shares. It is also referred to as the price multiple, or the earnings multiple. Benjamin Graham, known as the father of value investing and the mentor of Warren Buffett, helped to popularise the P/E ratio. In this article, we’ll explain the meaning of P/E ratio and how it can help guide your investment decisions.
What is Price-to-Earnings Ratio (P/E Ratio)?
The P/E ratio compares a stock’s price to its earnings. The ratio gives investors insight into whether a stock may be overvalued, appropriately priced, or undervalued and is a useful means of comparing stocks. P/E ratios can be applied to both shares and stock market indices such as the FTSE 100.
How to Calculate P/E Ratio?
The P/E ratio of a stock can be determined by using the company’s price per share and its earnings per share (EPS). Earnings per share is a company’s net profit divided by the number of outstanding common shares. Earnings per share can be either ‘trailing’ or ‘forward’. Trailing P/E ratio (the most widely used form) is based on the earnings of the previous 12 months, while the forward P/E ratio uses forecasted earnings.
The formula for P/E ratio is as follows:
P/E ratio = price per share/earnings per share
Now that we know the formula, let’s walk through calculating the P/E ratios of two similar stocks. Imagine there are two companies (Company X and Company Y) that both make and sell air purifiers.
Firstly, we’ll calculate the earnings per share (EPS) by using the earnings figures and the number of outstanding shares issued.
- Earnings: Company X earns £4 million per year and Company Y earns £5 million.
- Outstanding shares: Company X has 500,000 outstanding shares and Company Y has 400,000 outstanding shares.
With £4 million in earnings and 500,000 outstanding shares, Company X has an EPS of £8 (4,000,000/500,000).
With £5 million in earnings and 400,000 outstanding shares, Company Y has an EPS of £12.50 (5,000,000/400,000).
Now that we know the earnings per share of each company we can calculate the P/E ratios for each company’s stock. For this we must use the share price and the EPS.
- Share price: Company X is trading for £80 per share and Company Y is trading for £90 per share.
- Earnings per share: Company X has an EPS of £8 and Company Y has an EPS of £12.50.
We can now determine the P/E ratios by dividing the share price by the EPS.
- The P/E ratio of Company X is 10 (Share price of 80/EPS of 8). This means that its stock is trading at 10 times its earnings per share.
- The P/E ratio of Company Y is 7.2 (Share price of 90/EPS of 12.50). This means that its stock is trading at 7.2 times its earnings per share.
You do not actually need to do the calculation yourself as many finance websites and software platforms will tell you the P/E ratio of a stock, along with other metrics such as EPS, outstanding shares, dividend, and revenue per employee.
How to Use the P/E Ratio?
In the case above, although Company Y has a higher stock price, it may be a better investment because it has a lower P/E ratio. This is because the lower the P/E ratio, the less an investor is paying per pound of a company’s overall earnings.
A high P/E ratio signals that a company’s stock price is high relative to its earnings. If the company cannot keep up with growth expectations, the stock may be viewed as overvalued and see a reversal in price. A low P/E ratio indicates that the current stock price is low relative to earnings. If growth beats expectations the stock may be viewed as a bargain and attract buyers.
The ranges of P/E ratios vary widely by sector and industry group. For example, software companies have relatively high P/E ratios, since a fast growth rate is often expected. A high P/E ratio may reflect that investors anticipate rapid growth. Conversely, insurance companies usually have lower P/E ratios since they typically do not grow as fast. Low P/E ratios may reflect that investors see limited growth potential.
P/E ratios help to define stocks as either growth or value investments. For example, Tesla (TSLA) with a relatively high P/E ratio of 164 at the time of this writing, could be classified as a growth investment. Ford (F), with a current P/E ratio of 3.4, could be considered a value investment.
What is a Good Price to Earnings Ratio?
P/E ratios are most useful in comparing similar companies within a sector or industry. In this sense, judging what is a good P/E ratio is relative.
For example, if the average P/E ratio for the banking sector is 13 and an individual bank stock has a P/E ratio of 25, the bank may be overvalued and more likely to come under pressure if it fails to meet growth expectations. Conversely, another bank with a relatively low P/E ratio for the sector may be undervalued and likely to rally if it beats expectations.
A high P/E ratio does not necessarily mean a stock is overvalued. If a company with a high P/E ratio meets the growth expectations implied in its price it can prove to be a good investment. Likewise, a low P/E ratio does not guarantee that a stock is undervalued.
While P/E ratios provide important insights into the value of stocks, investors should be cautious about making decisions based on P/E ratios alone. Other important data points to consider along with P/E ratios include dividends, projected future earnings, and the level of debt at a company.
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