The price-to-earnings ratio, or P/E ratio, measures the price of a stock in relation to its earnings (or profits). In other words, it gives you the ability to compare two stocks and see which one would be more profitable, given their current share prices and earnings.
But what exactly does this number mean? Why do you even need to know this information? And how can you use it to inform your investment decisions? We’ll cover all of that and more in our ultimate guide to the price-to-earnings ratio (P/E).
Introduction: What is the Price-to-Earnings Ratio?
The price-to-earnings ratio (P/E ratio) is a measure of a company’s share price relative to its per share earnings. The P/E ratio is calculated by dividing the company’s current share price by its per share earnings. This measure is often used in conjunction with another popular financial metric: the dividend yield.
The P/E ratio is often used as a value indicator. For example, a low P/E indicates that investors expect good growth, while a high P/E means that investors are wary of high growth potential and/or uncertain about future prospects.
That said, keep in mind that there’s no clear rule of thumb for when to buy a stock with a given P/E ratio. A company can have very different fundamental drivers than its peers, so it may make sense to pay more or less than the market average based on your analysis. In other words, it’s never wise to blindly rely on an investing metric like P/E alone when making investment decisions.
The P/E Ratio Formula
The formula for P/E Ratio is:
P/E = Market Value Per Share ÷ Earnings Per Share
So, for example, if you have $10 worth of stock that has $1 in earnings, then your P/E Ratio would be 10 (or 10x). If you had $100 in stock with only $0.10 in earnings, then your P/E Ratio would be 1000 (or 100x).
P/E ratio is a way of measuring how much investors are paying for each dollar of earnings. But what does that mean? A P/E ratio essentially calculates how many dollars it takes to buy one share, or equity, of a company. If you have $100 and you want 100 shares of that company, then your P/E is going to be $1.00 (or 1x).
Conversely, if you have $1000 and you want 1000 shares, then your P/E will be 10 (or 10x). The lower a company’s P/E multiple is in comparison with other companies in its sector or industry group , they are considered undervalued because they appear relatively cheap when compared with their peers.
How to Calculate the P/E Ratio
One of the easiest ways to measure a company’s value is the P/E ratio. The P/E ratio shows how many times more a company is worth than its earnings per share. This number can give investors and analysts an idea of whether a stock is over or undervalued. To calculate the P/E ratio, divide the current market price by the last 12 months of earnings per share (EPS).
For example, if you want to know a company’s P/E ratio when it has $10 in EPS for the last 12 months, divide $10 by $10 (the current market price) and you will get 100. That means that for every dollar of earnings, this company is worth one hundred dollars in stock value on average.
It is important to note that you need a consistent number of quarters in your time frame. Say a company earned $2 per share in Q1 and $8 per share in Q2, but then only $5 per share in Q3. Because it would have four different numbers of earnings, P/E ratio would not be relevant or accurate. That is why analysts usually use three months, six months, and 12 months as their time frame for P/E calculation.
This way there will always be three quarters with two numbers each for both halves of their calculations. It helps remove anomalies that may appear if not having consistent data points.
Just like calculating any other P/E ratio, you will need to know some basic financial information about a company. The first thing is that it has to be listed on a U.S. exchange, such as NYSE or NASDAQ.
You will also need its stock symbol if you are looking up a specific company. It may seem difficult but with tools like Yahoo Finance and Google Finance, they can help you make your own calculations much easier and faster than before.[8] Here is an example of how Yahoo Finance lets users do their own math
What Does the P/E Ratio Mean?
The P/E Ratio is a popular measure of the price you would be willing to pay for a company’s earnings per share, which is also known as the multiple.
The formula for calculating the P/E Ratio is as follows: Market Cap ÷ Earnings per Share. In other words, this value reflects the number of shares it would take to buy one dollar of that company’s earnings. If your P/E ratio is 10x, you are paying 10x more than what the company’s current earnings are worth on the stock market.
That means if they are currently earning $1 in profit and their share value is $10, then you would pay $100 for one share.
A higher P/E ratio indicates that investors believe a company will do well in future, whereas a lower P/E ratio suggests that current performance is poor. A low P/E doesn’t always mean you should avoid buying shares in a particular company, but if it’s unusually low compared to others in its industry then there could be trouble ahead.
This occurs because all companies in an industry tend to have similar ratios, so if one is much lower than its competitors then it means there may be something wrong with it. For example, if Company A has a relatively high P/E of 20 and Company B has a relatively low P/E of 10 then Company B may have underlying problems that make their earnings grow slower or become less stable over time.
P/E Ratio vs. Other Ratios
A company’s P/E Ratio is calculated by taking the company’s share price and dividing it by its earnings per share. This ratio tells you how much investors are willing to pay for every dollar of a company’s earnings.
The higher a company’s P/E Ratio, the more expensive it is. A low P/E Ratio shows that investors may be skeptical about this stock because they are not getting a high return on their investment. However, in some cases, having a lower P/E Ratio can also be seen as an indicator of stability and predictability.
P/E Ratio Examples
A P/E ratio is a measure of a company’s current share price in relation to its per-share earnings. The P/E Ratio is calculated by dividing a company’s share price by the company’s earnings per share (EPS).
For example, if Company XYZ has an EPS of $0.50 and a share price of $10, then the P/E ratio would be 20 ($10/$0.50 = 20). This means that Company XYZ trades at 20 times their EPS.
How do you know what an appropriate range for P/E ratios is? Well, this depends on what industry you’re in and how fast companies can grow their profits.
The P/E ratio tells you what investors in general are willing to pay for a company’s earnings, and it’s considered a good starting point for analyzing a company’s stock.
As with most investment calculations, though, there can be exceptions: For example, companies can be overvalued if they’re growing their EPS extremely quickly while others may be undervalued if they’ve had stagnant or even negative growth over many years. So while P/E ratios are useful for spotting trends and determining whether a stock is priced reasonably, it never hurts to use some judgment.
P/E Ratio Limitations
1) The price of a stock reflects the market’s perception of all its assets, both tangible and intangible, future and current. One limitation of using P/E Ratio for valuation purposes is that it does not include any information about such assets.
2) Shareholders generally care more about their own holdings than they do about other shareholders in that company. If this mentality is prevalent among investors in the same industry, then there will be no benefit from diversification because all companies are being valued at or near their fair value.
3) Another limitation of P/E Ratio is that it ignores cash flows. If a company has poor prospects but sufficient cash, then its stock price may not accurately reflect fair value. Such a business would be viewed as undervalued by investors and its stock price would rise above its fair value until such time as its stock was fairly valued at zero, or perhaps even below zero. A similar scenario could play out in reverse.
For example, if you believe Tesla Motors Inc (TSLA) has great future prospects but is currently overvalued, then you could sell short on TSLA until fair value is achieved or the expectations for future growth are justified by current prices and trading volume.
4) A fourth limitation of P/E Ratio is that it focuses on a company’s earnings rather than its cash flows. Earnings can be affected by several factors, including debt loads, amortization of goodwill and intangible assets and changes in tax rates.
While higher earnings may imply higher potential future cash flows, comparing current P/E Ratios for different companies may not reveal their true underlying valuations. For example, companies with high debt levels will generally have lower net income because interest payments are subtracted from revenues before earnings are calculated.
As such, a firm with $1 million in revenues but paying $900,000 in interest could have a lower net income than another company that generates no revenues but pays out all its profits in dividends or stock buybacks.
Final Thoughts: Is the P/E Ratio Worth Following?
I hope you enjoyed the guide on how to calculate the P/E Ratio. The only question left is, is the P/E Ratio worth following? I think it is! It’s a great metric for determining how much you should pay for a stock.
That said, there are other metrics you should follow along with P/E that I didn’t discuss in today’s post. You can always use fundamental analysis to help you determine if a company is overvalued or undervalued.
If a company has an earnings yield of 20%, yet its P/E ratio is 30, it’s likely undervalued and an investment worth making. As Warren Buffet says, Price is what you pay; value is what you get. At first glance, it seems like he’s saying price and value are different things. In fact, he’s right—value simply tells you how much something is worth.