What Is a Price-to-Earnings (P/E) Ratio?

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DEFINITION

A price-to-earnings ratio, otherwise known as a P/E ratio, is a quick calculation used to evaluate how expensive, or cheap, a stock may be at any given time.

Definition and Example of a Price-to-Earnings (P/E) Ratio

Just as an appraiser can come out and give you an estimate of the value of your home, the price-to-earnings (P/E) ratio is a tool you can use to estimate the fair value of the stock market.

The P/E ratio is also a metric used to help compare stocks in the same industry to one another. It is not as useful when comparing stocks across different industries or those that produce different products and services.

Some industries are known to have much higher average P/E ratios than others, so only compare like with like.

For example, the hospital and healthcare sector had a P/E ratio of 20.77 in January 2022, while the software internet sector had a P/E ratio of 83.97.

How to Calculate a P/E Ratio

A P/E ratio is the price (P) divided by earnings (E).

Price to Earnings (P/E) Ratio

A stock with a price of $10 a share and earnings last year of $1 a share would have a P/E ratio of 10. If the stock price were to go up to $12 a share, and the earnings were to stay the same, the stock's P/E ratio would then be 12, and the stock would be relatively more expensive, because you would then be paying a higher price per dollar of earnings.

There are many ways to calculate P/E ratios. The most common three formulas used are:

  1. Look at the P/E ratio based on last year's earnings. This is also called the "TTM" method for "Trailing Twelve Months."
  2. Use a future forecast of earnings provided by the company or by stock analysts. This method is known as the "Forward P/E Ratio."
  3. Take a broader view by using a 10-year average of past earnings adjusted for inflation. This is something called "P/E 10," "Shipper P/E Ratio," or "CAP/E," which stands for "cyclical adjusted price-to-earnings."

How Price-to-Earnings Ratios Work

Price-to-earnings ratios for an individual stock must be interpreted much differently than P/E ratios for the market as a whole. The P/E ratio for the S&P 500 has ranged from a high of 40 during the tech bubble in the 1990s to a low of 7 at the bottom of a few bear markets.

The P/E ratio for an individual stock is telling you whether the market is overvaluing that particular stock based on how many people are willing to buy it, and its value over time. Generally, the lower the number, the better, because it suggests that the company may be undervalued and worth buying.

Limitations to P/E Ratios

Novice investors can often make the mistake of using a P/E ratio to buy a stock that appears undervalued, or to sell one that appears overvalued. They interpret the data too narrowly and forget that the "E," which is earnings data, is either past data (and the future may be different) or the earnings data is an estimate of the future (which may be different). For this reason, use P/E ratios with caution, and don't use them as a single decision-making tool. 

A volatile market can affect the short-term P/E ratio and make it less reliable. The P/E ratio also fails to include any consideration of future earnings growth.

P/E Ratio vs. PEG Ratio

The price-to-earnings-to-growth (PEG) ratio, meanwhile, incorporates earnings growth by measuring the ratio between the price/earnings ratio and earnings growth.

PEG Ratio equation
P/E Ratio vs. PEG Ratio
P/E Ratio PEG Ratio
Looks at share price vs. earnings per share Looks at share price vs. earnings per share vs. growth in earnings per share
Lower P/E ratio is preferable Lower PEG ratio is preferable
   
   

Key Takeaways

  • A price-to-earnings (P/E) ratio is a tool to evaluate the value of a stock price.
  • In its simplest form, it is price divided by earnings.
  • Different industries have different P/E ratios, so only compare like to like.
  • It's easy for novice investors to misinterpret the P/E ratio.
  • Many investors prefer to use the PEG ratio, which includes earnings growth.

Article Sources

  1. NYU Stern School of Business. "PE Ratio by Sector (US)."

  2. multpl. "S&P 500 PE Ratio."