What is a P/E ratio, and what is considered a good one?

What is a P/E ratio, and what is considered a good one?

A price-to-earnings (P/E) ratio is one measurement that investors may use to compare stock from multiple companies in the same industry. Investors also use a P/E ratio to compare a company’s stock against its historical performance or to compare one aggregate market against another. Calculating a P/E ratio helps investors determine whether they are paying too much for stock.

To calculate the P/E ratio, divide the stock’s current market price by its earnings per share (EPS). The P/E ratio helps investors determine whether a company’s stock is undervalued or overvalued when compared to its earnings.

A P/E ratio cannot be determined for any company that is losing money or has no earnings. Investors typically do not use it to compare stock prices across industries.

A P/E ratio is only one indicator of a company’s performance. If you are considering a stock purchase, consult with a financial advisor.

Comparing P/E ratios

Expected P/E ratios vary across industries, so they should only be used to compare companies in the same industry. When investors are comparing P/E ratios across businesses in the same industry, stocks with a lower P/E ratio are considered more favorable because traders will pay less for the stock for each unit of earnings the company records.

The average P/E ratio is between 20 and 25. If a company trades with a P/E ratio of 25x, investors expect to pay $25 for $1 of future earnings.

Anything below 20 is considered a favorable P/E ratio, and a P/E ratio above 25 is generally regarded as undesirable. Using the S&P 500 90-year historical chart for P/E, you can see that the S&P 500’s P/E was 26.25 in April 2024. The P/E ratio spiked to over 120 in 2009, after the recession. As stock prices change and companies release new quarterly earnings reports, P/E ratios fluctuate.

What are the potential drawbacks of using a P/E ratio?

A high P/E ratio may indicate that a company’s stock is overvalued, but it may also indicate that the company is expecting a high earnings growth rate in the future. A low P/E ratio may suggest that a company’s stock is undervalued, or it may mean that investors anticipate a decline in the company’s earnings.

When investors are evaluating potential stocks, they use multiple metrics to inform their decisions. Calculating a company’s earnings using a P/E ratio can be difficult because of differences in accounting practices and strategies a company may use on its books to devalue costs and inflate earnings.

A P/E ratio indicates a stock’s price when compared to its earnings, but a lower ratio may not be a positive indicator. It may indicate concerns about the company’s future performance.

What is the difference between a trailing and a forward P/E ratio?

A trailing P/E ratio is calculated using a company’s earnings over the previous 12 months. While a trailing P/E is more objective than a forward P/E, it assumes that a company’s past performance will correlate with its future performance.

The company calculates a forward P/E based on its expected earnings over the next twelve months. An accurate estimate of the company’s expected earnings is crucial for calculating a forward P/E.

If a company’s forward P/E is lower than its trailing P/E estimate, financial analysts expect earnings to increase. Similarly, if its forward P/E exceeds its trailing P/E ratio, financial analysts anticipate a decline in the company’s earnings.

The P/E 10 and P/E 30 measures assist investors in evaluating a stock’s long-term valuation by averaging performance over a period of 10 or 30 years. A long-term outlook can smooth out variations across multiple business cycles.

What other ratios or indicators should you consider when buying stock?

The opposite of a P/E ratio is an earnings yield. This is calculated by dividing the earnings per share by the stock price, and it is reported as a percentage. Investors more commonly use earnings ratios to calculate their rate of return on an investment.

A price/earnings-to-growth (PEG) ratio takes the company’s trailing price-to-earnings percentage and divides it by its earnings growth. It allows analysts to evaluate a stock’s price, the company’s expected earnings, and its growth rate. A stock with a PEG of less than one is considered undervalued, and one with a PEG of over one is considered overvalued.

When evaluating a company and its earnings potential, it is important to look for trends in its earnings charts, sales figures, and indicators of volatility, such as high turnover.

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Gabriel Katzner

In 2002, Gabriel Katzner received his Juris Doctorate with honors from Fordham University School of Law. After spending the first seven years of his legal career practicing at Cahill Gordon & Reindel LLP, an international law firm based in New York, he founded his own firm.

Gabriel identified key limitations in traditional estate planning—particularly the transient nature of client interactions and the suboptimal financial advice clients received elsewhere. Motivated to provide more enduring and comprehensive financial guidance, Gabriel established Frame Wealth Management. His aim was to extend client relationships and enhance their financial strategies, ultimately leading him to become a CERTIFIED FINANCIAL PLANNER™ and a CPWA® professional.

Years of Experience: 17+

This page has been written, edited, and reviewed by a team of legal writers following our comprehensive editorial guidelines. Additionally, it has been approved by attorney Gabriel Katzner, a CERTIFIED FINANCIAL PLANNER™, CPWA® professional, with 17 years of expertise in the legal field.