The P/E ratio compares the price per share of a company's stock with the company's earnings per share (EPS), allowing investors to determine whether a stock is overvalued or undervalued.
What is the P/E Ratio?
The price-to-earnings ratio, or P/E ratio, is a metric to express how much investors are paying per every $1 of earnings. The market price (P) of a share of stock is the amount that investors are willing to pay to own it. Earnings per share (E) is a company's earnings over the last twelve months, divided by the average number of shares outstanding.
If a company's shares are trading at $100 and its earnings per share is $5, then its P/E ratio would be 20. That means that a buyer of the share is investing $20 for every $1 of earnings.
P/E Ratio Formula
The formula for determining the PE ratio is:
P/E ratio = Market Value (Price) Per Share / Earnings Per Share
P/E ratios fluctuate constantly since a company's share price changes daily. Financial websites typically display the P/E ratio for companies experiencing losses or who have negative earnings or no profit as "not applicable" or "N/A".
Besides being used to compare individual stocks, the P/E ratio can also be used to evaluate entire stock indexes such as the . On March 8, 2022, the P/E ratio of the S&P 500 was 24.07. This is an average of all companies listed within the index.
How the Price-to-Earnings Ratio Is Used
P/E ratios provide a standardized way to analyze stocks that have different prices and earnings levels. They are used to:
- Determine Valuation of a Stock: A higher P/E ratio means a stock is more expensive relative to its earnings, and a lower P/E ratio means a stock is less expensive relative to its earnings; stocks or mutual funds having a high P/E ratio are usually classified as "growth" investments, and those having lower P/E ratios are usually classified as "value" investments.
- Compare Stocks: The P/E ratio can be used to contrast one stock against that of other stocks within the same industry or against the P/E ratios of stocks within the broader market, such as those comprising the S&P 500 Index.
- Predict Future Returns: Companies that grow extremely quickly, such as technology companies, have higher P/E ratios because investors are willing to pay a higher share price now on the expectation of high growth and greater earnings in the future.
High vs. Low P/E Ratios (Video)
It might seem intuitive to choose a stock having a low P/E ratio rather than one having a high P/E ratio because that company's earnings are greater compared to their share price, however, it's not that straightforward.
Let's take a look at two companies as of March 9, 2022 whose P/E ratios are vastly different:
- High P/E Ratio: The pet food company Chewy, Inc. (CHWY) has a high P/E ratio of 1,613.08, meaning that investors are spending $1,613.08 for every dollar of Chewy’s earnings; based on its growth potential, Wall Street analysts list Chewy as a "Buy".
- Low P/E Ratio: The venerable company U.S. Steel (X) has a low P/E ratio of 2.92, meaning that for every dollar of U.S. Steel’s earnings, investors need only spend around $3.00. Quants, or quantitative analysts, who use mathematical and statistical methods to analyze stocks place U.S. Steel as a "Strong Buy".
The reason for this discrepancy is that investors believe that Chewy, a company in the early phase of its growth cycle, will grow its earnings significantly quicker than U.S. Steel, a company that is much more mature.
3 P/E Ratio Types
1. Trailing Price-Per-Earnings
The Trailing P/E ratio, also known as "TTM" which is an acronym for "Trailing Twelve Months," is calculated by dividing a weighted average of the share price of common shares by the per-share net income over the most recent 12-month period. This takes into account the last four quarterly earnings periods, but since each company has its own fiscal year, the actual dates of the quarterly reports can vary from company to company. Only operational income is included in calculating the Trailing P/E ratio and income from discontinued operations, one-off items, write-downs, and accounting changes aren't included.
2. Forward P/E
Instead of using the previous net income, a Forward P/E ratio uses the net earnings expected over the coming 12-month period. This figure is usually the mean of estimates published by a certain group of analysts who cover the stock. The mean of any data set is found by adding all the values in the data set together then dividing that resulting figure by the number of values comprising the data set.
3. Shiller P/E Ratio
The Shiller PE, also known as the CAPE ratio, which is an acronym for Cyclically Adjusted Price Earnings ratio, is calculated by using a company's average earnings over the past 10 years, adjusted for inflation. It is often used to measure the valuation of the S&P 500 index. As of March 8, 2022, the Shiller P/E ratio for the S&P 500 was 34.45.
Comparing a stock's Forward P/E ratio with its Trailing P/E ratio is a good way for investors to envision what a company's future earnings might look like. However, some companies may be tempted to underestimate their future earnings so that when they actually come out, they appear to beat the estimates of analysts. Other companies may be tempted to overestimate their earnings in order to appear more attractive to investors.
Some financial websites only display the Trailing P/E ratio, but the Forward P/E ratio is also interesting. For example, if the Forward P/E is lower than the Trailing P/E ratio, that means that a company's earnings are expected to rise. If the Forward P/E ratio is higher than the Trailing P/E ratio, that company's earnings are expected to fall.
Benefits & Pitfalls of Using P/E Ratio
Advantages:
- The P/E ratio allows investors to compare a stock with that of the industry average and with that of competitors within the same industry.
- The current P/E ratio can be compared to that of past ratios, and if it stays somewhat constant but earnings have risen, then the share price is undervalued.
Limitations:
- The P/E ratio doesn't take into consideration a company's debt or financial structure. EPS is affected by a company's accounting practices such as depreciation and amortization methods, and its tax system.
- A low P/E ratio doesn't mean that a stock is a good buy. The company could be cheap due to a number of reasons such as it is losing customers or market share.
P/E Ratio Example
P/E ratio makes it easy to compare two stocks from Seeking Alpha's list of the Top Technology Stocks: Microsoft and SPS Commerce, Inc., even though SPSC is a small-cap stock and MSFT is a large-cap stock.
As of March 9, 2022, SPSC had:
- Market cap: 4.345 billion
- Share price: $128.41
- EPS (FWD): $2.03
- P/E ratio FWD: 63.15.
That means that the buyer of a share is investing $63.15 for every dollar of annual earnings, or that it would take almost 63 years of earnings to equal the price of one share.
By comparison MSFT had:
- Market cap: 2.068 trillion
- Share price: $288.50
- EPS ((fwd)): $9.44
- P/E ratio TTM: 30.55.
While Microsoft is trading at $100 more than what SPSC is trading at, we can see that it earns over four times as much per share, and its P/E ratio is lower by greater than half.
PEG Ratio vs. Price-Earnings Ratio
TA variation of the P/E ratio is the price-to-earnings to growth ratio, which is also known as the PEG ratio. The PEG ratio reflects a company’s value based on both its current and future earnings and is calculated by dividing a stock's current P/E ratio by the anticipated growth rate of the stock.
Stocks having a PEG ratio of 1 or less are generally considered undervalued because their prices are low compared to their expected growth. Some analysts believe that the PEG ratio is a more accurate measurement of value than the P/E ratio, but like the Forward P/E ratio, the PEG ratio is based on expected future growth which may not materialize.
Earnings Yield vs. P/E Ratio
The earnings yield expresses a company's earnings as a percentage of its stock price. It is calculated by dividing the earnings per share over the most recent 12-month period by the current market price per share. The P/E ratio is calculated by dividing a company's per share stock price by its earnings per share, thus the two formulas, one for the P/E ratio and one for the earnings yield are the reciprocal, or inverse, of one another.
Earnings yields are often compared to current interest rates on bonds and this comparison is known by the acronym BEER (Bond Equity Earnings Yield Ratio). By comparing bond yields to earnings yields, investors can form opinions as to whether stock prices will increase or decrease in the coming months. For example, Microsoft's current earnings yield is 3.33% while the yield on a 10-year treasury is 1.86%.
Bottom Line
The P/E ratio standardizes stocks or index funds that have very different market caps, share prices, and EPS levels. This makes it easy to compare and contrast them, and it allows investors to make informed buying and selling decisions.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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