Price-To-Earnings (P/E) Ratio

Why should I care about price-to-earnings (P/E) ratios?

For markets: The P/E ratio is used by investors to gauge if a stock is undervalued or overvalued compared to the market, industry peers, or its history. A company might have a higher P/E ratio when investor confidence in its prospects is high, thanks to high anticipated earnings growth, less risk, or other factors that might suggest the company is a more attractive investment. is high often prevail, reflecting investor confidence and the anticipation of growth in earnings. A lower P/E, meanwhile, could suggest the opposite.

Zooming in: Two elements make up a P/E ratio: price and earnings. For investors to have confidence that a P/E ratio is “right”, they need to have confidence in both parts of it. For example, a company with a low P/E might be considered undervalued if an investor believes the company’s share price is too low and should rise (perhaps thanks to stronger-than-expected earnings). Similarly, a high P/E company might be seen as overvalued if an investor believes that its earnings will fall short (meaning the unchanged share price, relative to lower earnings creates an even higher P/E ratio, which might trigger other investors selling).

What is a good price-to-earnings ratio?

A good price-to-earnings (P/E) ratio depends on the company, industry, wider market conditions, and investors’ growth expectations. Investors should assess P/E ratios together with other valuation metrics and fundamental analysis to understand a stock's valuation.

Historically, the average P/E ratio for the S&P 500 has ranged between 15 to 20, and currently sits at a forward P/E of 19.8. During periods of investor optimism, average P/E ratios climb higher as investors are willing to pay more for earnings in anticipation of continued profit growth. Conversely, in economic downturns, P/E ratios tend to fall as earnings drop and market sentiment wanes.

What do high and low P/E ratios mean?

• High P/E ratio: A high P/E ratio can either indicate that a stock is overvalued or that investors expect high earnings growth rates in the future. They’re typical of “growth” stocks but a too-high P/E ratio could also signal irrational exuberance from investors: any disappointment against lofty expectations could send the stock tumbling. Investors, then, spend a lot of time forecasting earnings to justify their view of P/E ratios. And traders, too, use technical analysis to predict where prices might go, which could offer valuation clues.
• Low P/E ratio: A low P/E ratio might suggest that a stock is undervalued, that investors expect limited earnings growth from the company, or that it’s experiencing difficulties. While lower P/E ratios can represent a buying opportunity, investors must discern whether the low P/E is due to temporary setbacks that the company can overcome thereby boosting first earnings and then the stock price – or more serious long-term issues have beset the firm.

How do you calculate a company's price-to-earnings ratio?

Calculating a company’s P/E ratio is straightforward. Here’s the formula:

• P/E = Share price / Earnings per share (EPS)

Share price: This is the current price of the company’s stock.

Earnings per share (EPS): This is the company’s net income divided by the number of shares in circulation. It can be calculated on a trailing basis (using historical data) or a forward basis (using future earnings estimates).

You can also calculate a P/E without going down to the per-share level, looking at a company’s total market value and net income.

• P/E = Market capitalization / net income

A P/E ratio shows you how much investors are, on average, willing to pay for a dollar of a company’s earnings. A higher P/E ratio means that investors are paying more for each dollar of earnings. Likewise, a lower P/E means investors are willing to pay less per dollar of earnings, suggesting they may be lower “quality”, less reliable, or expected to fall in the future.

What to consider when analyzing P/E ratios

Investors tend to use P/E ratios to compare companies, industries, stock market indexes, and entire markets within the same country or in different countries. That shows how flexible and informative a valuation metric it is. That said, P/Es are most effective when comparing companies within similar industries because they’re likely to share economic conditions, market growth rates, cost structures, and potential risks – thereby making a direct comparison more informative.

Technology and healthcare are two sectors in which investors might expect to see companies with higher P/E ratios, albeit for different reasons. Tech companies’ high P/Es usually reflect high earnings growth expectations, while healthcare companies typically have a lower but more predictable growth profile, justifying their valuations.

P/E ratios don’t capture differences in firms’ capital structure (i.e. the ratio of debt they have versus equity), so investors should be wary of drawing too-firm conclusions from comparisons between companies unless they have similar debt-to-equity ratios. For instance, a company with high levels of debt and therefore high interest costs will have lower net earnings than an identical company without debt. If both companies had the same share price, the debt-laden one would have a higher P/E which, rightly or wrongly, would distort any analysis.

Tax rates affect net income and therefore P/E ratios. Companies operating in countries with different corporate tax rates, then, will show different levels of post-tax profitability. When using P/E ratios for comparative analysis, consider the impact of taxation, especially for corporations headquartered in different countries.

What’s the difference between forward, trailing, and current P/E ratios?

Comparing trailing, forward, and current P/E ratios.

When to use each type of P/E ratio

• Trailing P/E is more valuable when analyzing companies in stable industries or during stable economic conditions where past performance reliably indicates the future. That’s because a trailing P/E tells you what investors are willing to pay for shares currently, relative to historical earnings – and if things don’t change much, it may indicate what they’re willing to pay in the future, too.
• Forward P/E is more valuable for companies or industries in which investors expect rapid changes – whether positive or negative – that drive shifts in financial outcomes. It's also more useful during periods of economic recovery, where future earnings are expected to improve versus recent history.
• Current P/E provides a snapshot that is more timely than trailing P/E and less speculative than forward P/E, making it a helpful starting point for analysis. It can be particularly useful for interim assessments where recent events such as mergers and acquisitions might impact earnings in the short term.

What are the limitations of P/E ratios?

The price-to-earnings ratio, while a valuable metric for stock valuation, has several limitations:

• Earnings volatility: The P/E ratio relies on earnings per share (EPS), which can be volatile year to year or quarter to quarter. That can lead to companies showing potentially misleading P/E ratios.
• Negative or zero earnings: Companies with zero or negative earnings (i.e. losses) cannot show a meaningful P/E ratio.
• Industry and country variability: P/E ratios vary across different sectors due to inherent differences in industry growth rates, business models, and prevailing tax rates. Investors should take these into account when comparing cross-sector and between regions.
• Accounting practices: Different accounting decisions and standards can affect reported earnings, thus altering the P/E ratio. This includes how companies handle depreciation, amortization, and other non-cash or non-recurring charges.
• Ignores capital structure: The P/E ratio does not consider a company’s debt levels, potentially overlooking some measures of financial risk in highly leveraged companies. That said, it does reflect the cost of interest payments captured in net earnings.
• Share buybacks: P/E ratios don’t ordinarily adjust for companies repurchasing and canceling their shares, reducing the number of them out there and, all else equal, increasing the EPS (same earnings and fewer shares equals a higher earnings per share measure). One way to avoid this impacting P/E analysis is to calculate the ratio based on market cap and net income instead of share price and EPS.

Frequently Asked Questions (FAQs)

Is a P/E ratio of 30 good or bad?

A P/E ratio of 30 isn’t necessarily good or bad. On the surface, it could indicate a company for which investors have high earnings growth expectations. However, it could also suggest a stock that’s overvalued. To know which it is, you’ll need to analyze the company’s own historical valuation, the current and past valuations of peers in the industry it’s in, and form a view on the company's own earnings growth prospects.

Is it better to have a high or low P/E ratio?

Neither a high nor a low P/E ratio is universally better. A low P/E may indicate either undervaluation or underlying issues just as a high P/E might reflect high growth expectations or an overvalued stock. Investors need to consider other factors to form a holistic view of a company’s valuation.

What’s the difference between an absolute and a relative P/E ratio?

An absolute P/E ratio is a standalone measure of a stock's valuation. A relative P/E ratio compares this measure against something else, like a peer, the historical P/E of the market, sector, or the stock itself, to offer clues about whether it might be over or undervalued.

What’s the difference between a company’s P/E ratio and its earnings yield?

A company’s earnings yield is the inverse of its P/E ratio: it’s calculated as earnings per share divided by the share price, and expressed as a percentage. A company’s earnings yield is often compared to bond yields.

What’s the difference between a P/E ratio and a PEG ratio?

P/E ratios show a company’s stock price relative to its earnings per share. PEG ratios, meanwhile, take the P/E ratio and adjust it for expected earnings growth. It aims to provide a more complete picture of a company’s valuation by factoring in future earnings growth.

Can you have a negative P/E ratio?

A negative P/E ratio would occur when a company has negative earnings (i.e. a loss) which are taken into the P/E calculation, and would typically cause financial distress or challenges within the company. While it’s possible to have a negative P/E ratio, it distorts analysis and is therefore pretty meaningless to investors.