Price-to-earnings (P/E) ratio is among the simplest evaluation tools in stock investment, and also one of the most misunderstood.
In this guide, we break down what a P/E ratio means and what a good P/E looks like. We will also show you how to use the price-to-earnings (P/E) ratio wisely in your own evaluation of stocks.
What is P/E ratio?
P/E ratio compares a company’s current share price to how much profit it earns per share. It shows how much investors are willing to pay now for one dollar of earnings.
The P/E ratio is influenced by several factors, including:
- Expected growth
- Interest rates
- Investor sentiment
- Industry trends.
Fast-growing businesses typically trade at a higher price-to-earnings ratio while slower-growing and more mature companies trade at a lower ratio.
Price-to-earnings ratio formula
The formula for calculating the price-to-earnings ratio is rather straightforward: it’s essentially the share price divided by earnings per share (EPS)
For instance, if a stock trading at $40 has earned $4 per share over a period of 12 months, its P/E ratio is 10. That means traders are paying $10 for every one dollar of earnings.
What makes a good price-to-earnings ratio?
There is no particular number that makes a good or bad P/E ratio; it all depends on context. However, many investors consider a price-to-earnings ratio below 20 to be reasonable, especially for established firms with steady earnings.
A good P/E ratio is typically:
- Lower than the company’s longstanding average.
- In line with or under industry peers
- Supported by stable or fast-growing earnings.
For instance, a stable consumer good company with a P/E ratio of 15 may be attractively priced, while a growing tech firm with the same ratio might be underpriced relative to its growth prospects.
A bad P/E, on the other hand, occurs when:
- The ratio is too high, but the company lacks strong growth to support it
- There is an inconsistent or declining share price
- The stock price increased due to hype instead of the fundamental factors
As a practical illustration, some fast-growing tech company stocks have traded at price-to-earnings ratios above 40. These figures can only make sense if future earnings grow rapidly. If growth slows down, the stock price can drop drastically.
How to use P/E ratio when investing in stocks
While the P/E ratio shows how much a stock investment earns for every dollar, it is better treated as a starting point rather than the final verdict. It helps determine whether a stock price is high or cheap compared to earnings, and can help give a vague indication of average stock market return.
You can use the price-to-earnings ratio to:
- Compare companies within the same industry
- Assess whether a stock is trading within, below, or above its historical price
- Help identify potential value investing opportunities when used with other tools
The limitations of using the price-to-earnings ratio as a metric
Like other stock valuation tools, the price-to-earnings ratio does have its limitations:
- It does not work properly for firms with negative earnings
- It does not account for debt and the strength of the balance sheet
- It can be distorted by one-time earnings occurrences
- On its own, the P/E ratio cannot be used to determine future growth
- It is unreliable for cross-sector comparisons as it varies across industries.
Forward P/E vs trailing P/E
The forward price-to-earnings ratio is based on projected future earnings, while the trailing P/E uses data from the past 12 months. Although trailing P/E may be more objective than forward P/E because it uses existing results, it does account for the current market conditions.
Forward P/E is helpful when a company is expected to experience rapid growth or recover from a previous setback. Its disadvantage is that it relies on future projections, which can be overly optimistic or entirely incorrect. Conservative and seasoned investors typically use both the forward and trailing P/E for a balanced perspective.
P/E ratio vs earnings yield vs PEG ratio
The P/E ratio is one method of stock valuation. Other related metrics that can add clarity include earnings yield and PEG ratio.
P/E ratio
The P/E ratio indicates how much investors are willing to pay for each dollar of earnings. It is particularly helpful when conducting quick comparisons and initial screenings.
Earnings yield
The earnings yield is the inverse of the price-to-earnings ratio. It is attained by dividing earnings by price. The earnings yield shows earnings as a percentage, which makes it ideal for comparing stocks with bonds and saving rates.
PEG ratio
The PEG ratio adjusts the price-to-earnings ratio by dividing it by the projected earnings growth. A PEG near 1 is typically perceived as a fair valuation, while higher figures indicate overvaluation.
The bottom line
A good price-to-earnings ratio is not about a particular number. It is about understanding what you are paying for profits in relation to growth, stability, and risk. When used properly, it can guide investment decisions, especially when used with other metrics and a long-term strategy.
