PE Ratio
The price-to-earnings (PE) ratio compares a company’s stock price to its earnings per share, showing how much investors are paying for each dollar of profit.
To calculate the PE ratio, simply divide the stock price by the earnings per share (EPS).
Formula: PE Ratio = Price Per Share / Earnings Per Share
In general, a low PE ratio suggests that a stock might be undervalued, while a high PE ratio could indicate that it’s overvalued.
However, a high PE ratio can also reflect strong future growth expectations—investors may be willing to pay a premium if they believe earnings will increase significantly.
The PE ratio is also known as the “earnings multiple” or simply “the multiple,” and it is commonly written as either PE or P/E.
One way to think about the PE ratio is as the price you pay for one dollar of annual earnings. For example, a ratio of 10 means you’re paying $10 for every $1 of earnings, which corresponds to an earnings yield of 10%.
If earnings remain steady, a PE ratio of 10 implies that it would take ten years to recoup your initial investment from the company’s earnings.
Investors frequently use the PE ratio to value individual stocks as well as entire markets or industries, and it also serves as a useful tool for comparing different stocks or sectors.
Formula: how to calculate the PE ratio
If you know a company’s stock price and its earnings per share, calculating the PE ratio is straightforward—just divide the stock price by the EPS.
You can easily find the stock price and EPS by entering the company’s ticker symbol on popular finance and investing websites.
Another method to calculate the PE ratio is to divide the company’s market cap by its total net income.
Formula: PE Ratio = Market Cap / Net Income
Examples
(Note: The numbers below are for demonstration purposes and may not be up-to-date.)
For example, Microsoft stock (MSFT) was trading at $165 per share, with an EPS of $5.30 over the previous 12 months.
This gives Microsoft a PE ratio of $165 / $5.30 ≈ 31.1. Although this is relatively high, it could be justified by the company’s strong earnings growth and promising future outlook.
In another example, General Motors stock (GM) was priced at $34.31, with an EPS of $6.14 over the past year.
In comparison, the S&P 500 had a PE ratio of 24.80. This means Microsoft was trading at a premium relative to the broader market, whereas General Motors was valued much lower.
Calculating General Motors’ PE ratio ($34.31 / $6.14) gives approximately 5.59—a low ratio that suggests the stock is cheap, possibly reflecting challenges in the automobile industry.
It’s common for fast-growing stocks to have high PE ratios. Over time, if earnings continue to grow, the high ratio may eventually seem more reasonable as earnings catch up to the stock price.
Different types of PE ratios
There are several variations of the PE ratio, mainly differing in which EPS figure is used as the denominator.
Trailing PE Ratio (standard)
The standard, or trailing, PE ratio uses the EPS from the trailing twelve months (TTM)—that is, the sum of earnings from the last four quarters.
By adding up the EPS for these four quarters, you obtain the trailing EPS figure.
When you see EPS or the PE ratio on most finance websites, it typically refers to the trailing-twelve-month numbers unless noted otherwise.
Keep in mind that the trailing PE ratio can sometimes be skewed by one-time charges or unusual events that affected earnings during the period.
Using an “adjusted” EPS that removes these anomalies might provide a more accurate picture of the company’s true valuation.
Forward PE Ratio
The forward PE ratio uses projected future EPS rather than past performance.
This is typically calculated by summing the EPS estimates for the next four quarters, or sometimes by using estimates for the next fiscal year.
The forward PE ratio indicates what the stock’s valuation might look like in a year if the current stock price holds and the earnings estimates are met.
Since it relies on estimates, the forward PE is inherently less precise than the trailing PE.
Often, the forward PE will be much lower than the trailing PE, suggesting significant expected earnings growth or the impact of one-time charges on past earnings.
Conversely, if the forward PE is higher than the trailing PE, it may indicate that earnings are expected to decline.
What is a good PE ratio?
Determining what constitutes a “good” or “bad” PE ratio can be challenging.
This is because the PE ratio doesn’t uniformly apply to all types of stocks.
For instance, companies with high growth potential often have elevated PE ratios, while those with slow or negative growth tend to exhibit lower ratios.
The PE ratio can be insightful for stable, value-oriented stocks, but it’s less useful for stocks that are rapidly growing or declining.
Here’s a general guideline for what might be considered a reasonable PE ratio based on growth expectations:
- No growth: 10 or lower
- Slow growth: around 12
- Moderate growth: approximately 15
- Fast growth: 25 or higher
However, never base your investment decision solely on the PE ratio—no single metric can provide a complete picture of an investment’s potential.
The PEG Ratio (Price/Earnings to Growth)
A useful way to gauge whether a stock’s PE ratio is justified is to consider the company’s earnings growth rate through the PEG ratio (Price/Earnings to Growth).
To calculate the PEG ratio, divide the PE ratio by the company’s earnings growth rate. This metric is particularly valuable for assessing fast-growing companies.
For example, if a stock has a PE ratio of 20 and is growing at 20% per year, its PEG ratio would be 1.
A PEG ratio below 1 may indicate that the stock is undervalued relative to its growth rate, while a PEG significantly above 1 suggests it could be overpriced.
Like the PE ratio, the PEG ratio can be calculated on a trailing or forward basis depending on whether you use historical or projected earnings growth.
PE ratio of industries, sectors and markets
The PE ratio is frequently used to compare groups of stocks.
For example, you can calculate an average PE ratio across entire indexes, markets, sectors, industries, or even countries.
Some investors compare the PE ratios of the US and European stock markets to determine which might offer better opportunities.
Others use the PE ratio to contrast the valuations of different industries, such as technology versus financial services.
Examining average PE ratios can provide insights into whether certain sectors, industries, or markets are overvalued or undervalued, though it’s important to note that some industries naturally exhibit higher or lower PE ratios due to differing growth prospects and market conditions.
Historical PE ratios
Comparing current PE ratios with historical averages can be very revealing.
Sometimes, dramatic increases in stock prices are driven largely by expanding PE ratios rather than improvements in earnings.
Rising PE ratios can be an indicator of a market bubble, as they suggest that stock prices are increasing much faster than earnings.
For example, during the dot-com bubble of 1999–2000, you might have noticed sky-high PE ratios (often over 40) and chosen to wait on investing.
By considering both current and historical PE ratios along with other valuation metrics, you can better protect yourself from market bubbles, fads, and manias.
PE ratio vs earnings yield
The earnings yield is simply the inverse of the PE ratio (often referred to as the E/P ratio).
To calculate the earnings yield, divide the EPS by the stock price and then multiply by 100 to get a percentage.
Formula: Earnings Yield (%) = (EPS / Stock Price) * 100
For instance, if a company’s stock is priced at $20 with an EPS of $1, it has a PE ratio of 20 and an earnings yield of 5% (($1 / $20) * 100).
Comparing earnings yields can be particularly useful when evaluating different investment opportunities. For example, while a savings account might yield 2%, a stock with a 5% earnings yield and growing earnings could represent a more attractive long-term investment—though keep in mind that stocks carry higher risks.
Negative PE ratios
When a company has negative earnings per share, it also results in a negative PE ratio.
Many financial websites will display “n/a” (not applicable) instead of a negative PE ratio because a negative figure doesn’t provide much useful information.
Companies can post losses for a variety of reasons, and a negative PE ratio does not necessarily mean the business is unsustainable. One-time expenses such as writedowns or tax charges can temporarily distort EPS and the PE ratio.
Additionally, rapidly growing companies often reinvest all their earnings to fuel expansion. Even if their PE ratio is negative, these companies can still offer substantial long-term growth potential. For example, Amazon (AMZN) has at times shown a negative or very high PE ratio, yet it has consistently grown its market share.
Limitations of the PE Ratio
The PE ratio is popular because it is both easy to calculate and understand.
However, it has significant limitations and should not be used in isolation to determine whether a stock is a sound investment.
It’s crucial to consider other valuation metrics and examine the company’s future growth prospects.
Basing an investment decision solely on the PE ratio can be risky—often, stocks that seem cheap are so for a reason, while some of the best-performing stocks may have very high PE ratios (as seen with companies like Amazon).
Moreover, the EPS figure can be misleading due to complex accounting practices. For example, a company might report positive EPS while actually experiencing negative free cash flow, meaning it’s spending more cash than it earns.
In the end, no single metric can fully capture a stock’s investment potential. While the PE ratio provides a quick snapshot of a company’s valuation, it is just one piece of a much larger puzzle.
Happy investing!