What is a P/E ratio?
Editorial staff, J.P. Morgan Wealth Management
- A price-to-earnings (P/E) ratio is the ratio of a company’s share price to its earnings per share (EPS).
- Investors use P/E ratios to compare performances of similar companies and to compare companies against their own historical records.
- There are two main types of P/E ratios: forward P/E and trailing P/E. These metrics are calculated by looking at a company’s projected earnings and past earnings, respectively.
- A high P/E ratio might indicate that a stock’s price is high relative to its earnings, potentially suggesting that the stock is overvalued. Conversely, a low P/E ratio may mean that a stock is undervalued.
Price-to-earnings (P/E) ratio, sometimes referred to as the P&E ratio or P E ratio, stands for the ratio of a company’s share price to its earnings per share (EPS).
Investors use this ratio to compare the performances of similar companies and to compare companies against their own historical records. The price-to-earnings ratio is sometimes also called the price multiple or the earnings multiple.
Why are P/E ratios useful?
The P/E ratio tells you how much investors are willing to pay for each dollar of a company’s earnings. A high P/E ratio may indicate that a stock’s price is high relative to its earnings and potentially suggest that the stock is overvalued. On the other hand, a low P/E ratio might mean that a stock is undervalued.
What is the P/E ratio formula?
To calculate a P/E ratio, divide the company’s stock price, or market value per share, by its EPS.
Price-to-earnings (P/E) ratio = Current stock price / Earnings per share (EPS)
To find out a company’s current stock price, simply type its ticker into any finance website. Then you’ll have to take a few additional steps to find the company’s P/E ratio.
There are two main types of EPS measurements, and they are used to calculate the two primary types of P/E ratios:
- One type of EPS figure is called “trailing 12 months” or “TTM.” This data point shows how the company has performed over the past year. This number can often be found in a company’s annual report.
- The second kind of EPS – estimated future EPS – also comes from a company’s annual report and represents the company’s best estimate of what it will earn in the future.
You’ll want to figure out which EPS figure you want to use to calculate a company’s P/E ratio. Using these figures, analysts may calculate “trailing P/E” or “forward P/E.” Each type of P/E ratio has advantages and disadvantages. Trailing P/E is the most widely used form of the metric because it is the most objective as it is based on actual performance data.
Forward P/E is always based on an educated guess. Because a company’s performance in the past does not always correlate to how it will fare in the future, some investors prefer to look at forward P/E.
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P/E ratio calculation example
Say you want to compare two companies that make air conditioners. To calculate their P/E ratios, you’ll need to know a few things.
Share price
Let’s say Company A’s share price is $60, and Company B’s share price is $10. At first glance, it may seem that Company B is the better value since you can buy six shares of Company B for the same amount that it costs to buy one share of Company A.
But share price alone isn’t always a clear sign of a company’s value. After all, if you bought one share of Company A and the stock price went up, you’d make money. if you were to buy six shares of Company B and its value stayed the same or went down, you’d lose money.
This is why investors may look at a company’s P/E ratio – because it may give a more complete picture of an investment.
Annual earnings
The next factor to consider is a company’s annual earnings. Say Company A is located in Florida, where demand for air conditioners is high. This company earns a profit of $100,000 per year. Company B is located in Maine, where demand for air conditioners is lower. It makes a profit of $10,000 per year.
Earnings per share (EPS)
Now that you know each company’s share price and each company’s earnings, there is one more piece of information required. You need to know how many shares each company has issued. You can then divide this number by the annual earnings to calculate the value of each share relative to the company’s overall earnings.
This data point is called earnings per share, or EPS. Going back to the previous example:
- If Company A has $100,000 in earnings and 50,000 outstanding shares, this would mean it would have an EPS of $2.
- If Company B has $10,000 in earnings and 10,000 outstanding shares, it would have EPS of $1.
Calculating the P/E ratio
Now that you have determined both company’s EPS values, you can find their P/E ratios.
Company A: Divide the company’s share price ($60) by its EPS ($2) to get a P/E ratio of 30. This tells you that the stock is trading at 30 times the company’s EPS.
Company B: Divide the company’s share price ($10) by its EPS ($1) to get a P/E ratio of 10. This tells you that the stock is trading at 10 times the company’s EPS.
How to use the P/E ratio as an investor
A company’s P/E ratio isn’t the be-all-end-all metric for investors, but it does offer a window into the value, or lack of value, for a stock, that investors may find useful. Many investors will use it to determine if a stock is a growth stock, a value stock, or just to make a determination if a stock is overvalued for whatever reason.
Growth stock
A higher P/E ratio may indicate that a company could be considered a growth stock. This is a company with higher expectations of future earnings growth, and investors may be baking in that assumption, which is reflected in the company’s stock price. Because the potential for growth exists, investors may want to buy stock in a company, even if the price is higher, because of the potential future opportunity for supercharged growth.
Value stock
A lower P/E ratio may indicate that a stock could be a value stock. These are stocks that investors may see as undervalued in the stock market, but with strong company fundamentals. The thought with value stocks is that the company’s share price will eventually correct to reflect the company’s fundamentals.
Indication that a stock is overvalued
Beyond investors using P/E ratios to determine if a stock is a growth stock or a value stock, they may also just use this metric to determine that a stock is not a good investment. When a company has an unusually high P/E ratio compared to its industry peers or historical averages, it could indicate that the stock is overvalued.
Indication that the market expects the stock to decline in the future
A low P/E ratio can sometimes be a negative signal to investors. It may indicate that the market expects earnings to decline in the future or that the company has significant risks, structural problems or other issues on the horizon.
The P/E ratio is just one piece of the puzzle
Although the P/E ratio is one of the most popular ways to evaluate a stock, it is not the only indicator investors should consider. For example, some stocks might have low P/E ratios because they have low growth potential.
Looking at the scenario from above, if Company B only sells air conditioners in Maine, it might not be as likely to grow as Company A in Florida. However, if both companies look like they will grow at similar rates, Company B might be the better investment because of its low P/E ratio.
It is also important to remember that a high P/E ratio isn’t always a bad thing, especially a high trailing P/E. Maybe Company A has recently invented an energy-efficient air conditioner and is poised for growth. This might not be reflected in its trailing P/E but could be evident in its forward P/E.
The bottom line
P/E ratios give investors valuable insights about stocks and allow them to make helpful comparisons between companies. However, when evaluating investments holistically, it is important to look at other factors – like dividends, projected future earnings and other data points – in addition to P/E ratios.
FAQs
In general, there’s no agreed-upon number for what a good P/E ratio is. The number is going to need context. Companies with a higher P/E ratio may be a growth stock, for instance. Companies with a lower P/E ratio could be considered a potentially good investment because it might indicate that a company is undervalued.
A lower P/E ratio is generally considered better because it implies that the business – and its stock price – is potentially undervalued. But again, the number needs context. A company with a high P/E ratio may be a growth stock with huge future opportunity for investors, as an example.
Another formula investors may use to determine a company’s growth potential is the price-to-earnings-to-growth (PEG) ratio. The PEG takes a company’s current P/E and divides it by its 5-year projected growth rate.
Let’s assume that Company A, with a P/E of 30, expects to grow by 10% over the next five years. This would give the company a PEG of 3.0. If Company B, with a P/E of 10, expects to grow by 20% over the same period of time, this would give it a PEG of 0.5. The lower a company’s PEG, the more likely it is to be undervalued. This could make it a stronger investment, but also an investment that may carry more risk.
One metric investors may use to gauge an investment’s potential is its P/E 10 or P/E 30 measures. These figures measure a company’s P/E over a 10- or 30-year period. By weighing this against a stock index – like the S&P 500 – or the average P/E for similar companies in a particular market sector – investors can gauge whether a company has been over- or under-performing similar companies over time.
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Editorial staff, J.P. Morgan Wealth Management
