- How does the P/E ratio work?
- So, what is a good P/E ratio?
- P/E ratio formula and calculation
- Forward P/E ratio
- Trailing P/E ratio
- Valuation from P/E
- Investor expectations
- What about earnings yield and price-to-earnings-to-growth (PEG) ratio?
- Earnings yield
- PEG ratio
- Absolute vs relative P/E
- P/E ratio limitations and other considerations
What is the price-to-earnings (P/E) ratio?
The price-to-earnings (P/E) ratio determines a company's value. At its simplest, the ratio reveals what the current market is prepared to shell out for the company's shares based on earnings, past or future. Therefore, it shows what people are prepared to invest for each dollar earned.
How does the P/E ratio work?
Used by investors and analysts to determine a company's value, the P/E ratio measures the current share price against the company's earnings per share (EPS). This calculation is also called the 'earnings multiple' or 'price multiple'.
Simply, a share's P/E ratio tells you how much investors will pay per dollar of the company's earnings. It provides a standardised way to compare the prices of different shares by benchmarking their share price against their earnings. It can help you determine whether a stock is currently undervalued or overvalued.
However, we can use the P/E ratio in all sorts of ways.
It can reveal whether investors anticipate future growth in the company's earnings. Company management might also use the P/E ratio internally to analyse its performance over time by examining historical patterns. Similarly, analysts might use it to make comparisons between aggregate markets.
So, what is a good P/E ratio?
There is no simple answer to this question. It depends on how we calculate the P/E ratio and what we want to use it for. A high P/E ratio can indicate a share is overvalued. Conversely, a low P/E ratio can tell that a share is undervalued.
But what constitutes a high or a low P/E ratio will depend on the company's industry. Technology stocks, for example, tend to have a higher P/E ratio than consumer stocks.
This is because many tech stocks are growth stocks, which investors buy assuming their earnings will grow. So, many investors are happy to pay a relatively higher price today so they can 'get in on the ground floor' of the next big thing.
P/E ratio formula and calculation
Calculating the P/E ratio is relatively straightforward – you just divide a company's share price (or market value per share) by its earnings per share:
P/E ratio = market value per share ÷ earnings per share
For example, if the share price is $10 for a company earning $1 per share, the price-to-earnings ratio is 10x (meaning ten times the earnings).
Of course, we can determine EPS in different ways, resulting in the two most commonly used varieties of P/E ratio: trailing and forward.
The trailing variety examines earnings performance over the previous year, while the forward calculation incorporates anticipated future earnings to determine the ratio.
A separate construction of the P/E ratio looks at longer-term trends by considering earnings averages over ten years (P/E 10) or even 30 years (P/E 30). This can be helpful in accounting for fluctuations in the overall business cycle, particularly when looking at the value of a share market index overall.
Forward P/E ratio
Using forward estimates of EPS to determine the P/E ratio is useful when considering the projected value of a business. However, as this is only based on an educated guess and therefore subject to several variables, the forward P/E ratio can be unreliable (and easily manipulated).
A company may have reasons to underestimate or overestimate future earnings. The forward-focused calculation is, therefore, the less common of the two P/E ratios.
Trailing P/E ratio
The trailing P/E ratio employs the more concrete calculation of EPS based on the past 12 months. As long as a company has reported trailing earnings correctly, it is a more objective metric that investors can trust, as it's not based on a guess.
However, this does not mean the trailing ratio is the perfect measure. For instance, in considering only past performance, it cannot take expected growth into account.
Valuation from P/E
We can use the P/E ratio in different ways. It might not be the only metric that values a company, but it is one of the most commonly used.
As we touched on earlier, the P/E ratio reveals what the current market is prepared to shell out for the company's shares based on earnings, past or future, and therefore shows what people are prepared to invest for each dollar earned.
For instance, at a P/E of 10x, you would expect to earn $1 for every $10 you pay.
This is important because, as a company's shareholder (or part owner), you have a right to the company's earnings. When a company is profitable, it can return some of those profits to investors as dividends, or it can reinvest its earnings into growing and sustaining its business (hopefully resulting in a higher share price).
Either way, this should result in money in your pocket as dividend income or capital growth.
It means that, along with other common metrics like return on equity (ROE) or the price-to-book ratio (P/B ratio), a stock's P/E ratio can be one of the most pertinent data points potential investors should consider before buying (or selling) a stock.
Taking Coles Group Ltd (ASX: COL) as an example, the share price at the end of trade on 23 February 2024 was $15.73, with a trailing EPS of 77.9 cents. Therefore, we can calculate the P/E ratio as follows:
15.73 ÷ 0.779 = 20.19
When rounded, this is expressed as a ratio of 20.2x. Or, put another way, investors paid around $20.20 for every dollar earned (based on the previous year). P/E ratios are particularly useful in determining the value of a stock when compared with other operators in the same industry group.
Investor expectations
P/E ratios tell us several things about shareholder expectations. A relatively low P/E ratio could mean that investors believe the company is struggling to perform as well as others in the same industry, or it may show the stock is simply undervalued.
Conversely, a high P/E ratio may indicate how much growth investors anticipate in future earnings for the stock. Companies with a high growth rate tend to have higher P/E ratios, while a lower P/E ratio can indicate investors do not expect the same extent of earnings growth.
There's no specific P/E ratio that indicates a share is cheap or expensive, just as there is no such thing as a good P/E ratio. However, investors generally consider stocks with P/E ratios of below 15 as cheap, while shares with a P/E above 18 can be thought of as expensive. Of course, the P/E ratio of a share will depend on investor expectations of the company's earnings and cash flow.
What about earnings yield and price-to-earnings-to-growth (PEG) ratio?
Of course, the P/E ratio is not the only measure available to investors. Other metrics sometimes used to assess company value include the earnings yield, cash flow ratio, and the PEG ratio.
Earnings yield
This metric is the inverse of P/E, where EPS is divided by the share price and expressed in percentage form. Accordingly, this provides the same information as P/E but in a different manner.
While earnings yield focuses on the rate of return for the investment, the P/E ratio provides a more direct focus on growth in value over time.
The earnings yield assists analysis where a company has no (or negative) earnings, whereas the P/E is not applicable here.
PEG ratio
The PEG ratio is a variation on P/E in that it provides more comprehensive information by considering the connection between P/E and the growth in earnings.
A low PEG (less than one) indicates that the share price underestimates earnings growth. A higher PEG (more than one) shows investors have overestimated growth.
PEG is an example of how P/E can be used in other calculations to reveal even more about a stock's value.
Absolute vs relative P/E
You may also come across references to absolute and relative P/E. The absolute ratio is calculated in the usual fashion detailed above (based on the current EPS). In contrast, relative P/E compares against a benchmark of past ratios over a particular timeframe, such as five or ten years.
When discussing P/E, investors generally accept the absolute metric as the common standard metric. However, the relative ratio can be valuable for considering developments over time.
P/E ratio limitations and other considerations
As worthwhile as the P/E ratio is, all we end up with is a number that we can interpret in various ways. So, it does come with certain limitations.
It is particularly beneficial when comparing companies within the same industry. However, it is not an absolute measure that can effectively compare shares across different sectors. For example, you wouldn't compare the P/E ratio of a travel share against a financial share. Similarly, P/E does not effectively deal with companies that are not profitable or have negative earnings.
The P/E ratio has many applications for investors, companies, and analysts. But, it is essential to understand what it means and how it can help you assess a company's performance.
It can provide a meaningful insight into stock value when employed correctly. It is certainly not the only metric of its kind, but it is one of the most important and widely used.
- With additional reporting by Motley Fool contributor Rhys Brock
Frequently Asked Questions
-
Typically, we consider stocks with a P/E ratio less than 15x earnings as 'cheap', while those with a P/E ratio above 18x earnings are considered expensive.
However, applying these sorts of blanket generalisations takes nuance out of the P/E ratio because it doesn't allow for the fact that P/E ratios can vary wildly from one market sector to the next.
You should never forget that the P/E ratio is a relative financial metric. It is best used when comparing the performance of different companies, usually within the same industry group. For example, tech stocks tend to have high P/E ratios, so comparing them with insurance or finance companies with low ratios wouldn't make sense.
-
The P/E ratio tells you how much the market will pay per dollar of a company's earnings. In this way, the P/E ratio helps you determine whether a company's stock is fairly priced. A share with a low P/E ratio could mean it's a bargain -- whereas one with a very high P/E ratio could be expensive.
However, on its own, the P/E ratio doesn't tell you all that much about a company's valuation. Only once you start comparing it against the company's peers does the P/E ratio really become a helpful tool for stock picking.
For example, you might find out that a stock you're interested in buying has a P/E ratio of 10. It seems cheap, right? You might think that's worth snapping up -- until you discover that the average P/E ratio of its peers is five, which might now mean it's overpriced.
While useful, the P/E ratio also has its limitations, so it shouldn't be the be-all and end-all when choosing which shares to buy.
-
The P/E ratio tells you how much the market will pay per dollar of a company's earnings. Therefore, if a company has a P/E ratio of 30, the market is willing to pay $30 for $1 of the company's earnings. For this reason, the P/E ratio is sometimes referred to as the 'earnings multiple' or 'price multiple'. You might hear analysts say a stock is trading at '30 times earnings' – it's the same as saying it has a P/E ratio of 30.
We can calculate the P/E ratio in different ways. The 'trailing' P/E is the most commonly used metric, dividing the stock's current price by its earnings per share over the prior 12 months. A 'forward P/E' instead uses expectations of future earnings.
The forward P/E can sometimes be better for valuing growth stocks where earnings rise exponentially. However, it is also less certain and relies on forecasting and modelling, which may not reflect reality.
