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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