The price-to-earnings ratio, or P/E ratio, is a common metric used to gauge the value of a company's stock. It uses the company's current earnings to give investors an indication of whether the company's share price is overvalued or undervalued.
What Is the P/E ratio?
Investors value earnings because they want to know how profitable the company is and how much profits it will earn in the future to make an investment decision. Is buying a stock price at its current market price a good investment or not?
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A P/E ratio is the company's current share price divided by its net income earnings per share, sometimes referred to as the "earnings multiple."
Consider also: How Is a P/E Ratio Used?
Calculate a P/E Ratio
Take the company's current stock price and divide by its earnings per share for the previous 12 months. For example, suppose the current stock price for Company A is $40, and it had $2 in annual earnings per share for the previous year. Its P/E ratio would be 20 ($40 divided by $2).
You can also calculate the earnings yield by taking the inverse of the P/E ratio. In our example, dividing $2 in earnings per share by the current stock price of $40 gives an earnings yield of 5 percent.
What Does Price-Earnings Ratio Mean?
Analysts and investors use P/E ratios to determine the values of investments relative to each other. It's one part of the research process. Is a company's stock price a bargain, or is it expensive relative to its income?
Companies with higher P/E ratios generally have higher expected growth rates. As examples, tech companies are considered growth stocks and generally have high P/E ratios; banks have more stable growth rates and usually have lower ratios.
What’s a Good P/E Ratio?
To understand the significance of a P/E ratio you must compare a company's P/E to its historical ratio or to other competitors in the same industry. It's difficult to determine if a P/E is a bargain or expensive without making comparisons.
Investors want to know if the company's share price is cheap or expensive. A company's P/E by itself isn't very useful. It must be compared to other benchmark P/Es to get a sense of its valuation. Here are several references to use for comparison:
Historical: Look at the company's P/E ratios over the past several years to get a benchmark for comparison. Is its current P/E ratio higher or lower? If the current P/E ratio is higher, it could be that investors are expecting the company's earnings to increase and the stock price has gone up. On the other hand, a high P/E could indicate that the company's earnings have decreased, and the stock price is now overvalued. This type of analysis must be done within the context of other financial fundamentals and metrics.
Competitors: How does the company's P/E compare to its competitors and similar companies? A high P/E ratio could indicate that it's outperforming its competition, whereas a low P/E could mean it's lagging behind.
Compare to market: How does the company's P/E compare to the overall stock market indices, such as the Standard & Poor's 500 index or the NASDAQ? Is the company's P/E higher or lower than the overall market?
Types of P/E Ratios
There are three ways to calculate P/E ratios:
Trailing: For this ratio, you take the company's current stock price and divide by its earnings per share for the past 12 months. You can find these past performance figures in the company's financial statements. However, a trailing P/E ratio is no indication of the company's future performance.
Forward: When companies make projections of their expected future earnings, you can calculate a forward P/E ratio and compare it to the company's historical ratio to get a sense of its direction and growth prospects.
Shiller ratio: The Shiller P/E ratio focuses on the S&P 500. It uses the inflation-adjusted average earnings for all the companies in the index for the past 10 years. Wall Street brokerage analysts use the Shiller ratio to get a better feel for earnings after inflation over a longer trend. It is not normally used to evaluate individual company performance or industry sectors.
Consider also: How to Calculate EPS Growth Rate
What Is the PEG Ratio?
While the P/E ratio is helpful in determining the value of a company's stock price relative to its earnings, it doesn't consider the company's growth rate. The PEG ratio combines a company's P/E ratio with its earnings growth rate to get a better valuation. To find the PEG ratio, divide the company's P/E ratio by its projected earnings growth rate.
For example, suppose analysts project Company A's earnings growth at 12 percent for the next three years. Its PEG ratio would be: 20 divided by 12, or 1.67 times.
Now suppose you're comparing Company A to Company B, which has a P/E ratio of 25 and a higher earnings growth rate of 18 percent. Which company represents the better value?
Company B's PEG ratio would be 25 divided by 18, or 1.39. In this comparison, Company B is a cheaper value, 1.39 PEG versus 1.67 PEG for Company A, even though its P/E ratio is higher than Company A's.