Investors are always looking for bargains. But the mantra "buy low, sell high" is much easier to recite in the mirror than practice in the markets. Investors must use different metrics and tools to evaluate companies beyond their share price to find discounted stocks.
Of course, investors have all kinds of timelines and ideas, and they must use different tools to reach their goals. If you have a long-term investment view, you’ll likely focus more on fundamental metrics than technical stock price data. Fundamental analysis provides an "under the hood" view of a company’s financial picture, and the price-to-earnings (P/E) ratio is an important metric in determining whether a company is worth its current stock price.
In this article, you’ll learn how to calculate P/E ratios, how to apply the metric in your own stock analysis, and the drawbacks that must be considered when using it to evaluate different companies.
What Is the Price-to-Earnings Ratio?
It’s easy to look up the price of a public company’s stock, but how do you know if you’re getting a good deal? Predicting the future path of stock prices is complex and requires analysis and some projection. One tool used to analyze a stock's value is the P/E ratio.
The P/E ratio tells you exactly how much investors will pay per dollar the company earns. The P/E ratio is an uncomplicated and easy-to-calculate metric, making it prevalent in analyzing a wide range of stock sectors and industries. However, it’s also a limited tool that investors must use appropriately to provide any worthwhile analysis. Knowing what P/E doesn’t tell you is just as important as knowing what it does.
How to Calculate P/E
One of the reasons P/E is popular is its simple calculation. To find a stock’s P/E ratio, you simply divide its current market price by its earnings-per-share (EPS) figure.
- P/E Ratio = Current Stock Price / EPS
For example, if Company X has a stock price of $100 and an EPS of 10, you’d divide 100 by 10 and get 10. Company X has a P/E ratio of 10, meaning investors are willing to pay $10 today for every $1 of company earnings.
Types of P/E Ratios
Where does the EPS figure come from in the P/E formula? Unlike many stock analysis tools, P/E ratios can be backward or forward-looking, depending on which version of EPS is used.
Trailing P/E Ratio
To find the trailing P/E ratio, you used the previous 12 months' earnings in the EPS figure. These are accurate, hard numbers, but they don’t consider earnings growth prospects. Trailing P/E is a backward-looking metric that occasionally provides a misleading view of the future.
Forward P/E Ratio
Instead of using the figures reported in the previous 12 months of earnings, the forward P/E ratio uses company guidance and projections to measure the expected ratio over the next 12 months. This metric is forward-looking, but relying on estimates and forecasts can produce inaccuracies.
What the P/E Ratio Tells Investors
P/E is a valuation metric that helps investors evaluate stocks based on earnings potential. You’ll occasionally hear an investor say, “Company X trades at 25x earnings.” This is simply another turn of phrase, as Company X has a P/E ratio of 25 in this scenario, but it highlights what type of information the metric provides.
Generally, investors prefer low P/E stocks to high P/E stocks, but (as with most investment analysis tools), you need context to use the information correctly.
High P/E Ratio (> Market Average)
Right now, the S&P 500 has an average P/E ratio of 29.27, up almost 30% from the lows of the 2022 bear market but still well below the post-COVID high of 38.3 at the end of 2020.
If you’re researching a company and find it has a P/E ratio substantially higher than this market average, you’ll need to ask two questions:
- Is this stock anticipating higher-than-average growth?
- Could this stock be overvalued and due for a pullback?
A high P/E ratio doesn’t always mean an overvalued stock, especially if it resides in a growth-obsessed sector like tech. However, further inspection is likely warranted if the P/E ratio is significantly higher than market averages.
Low P/E Ratio (< Market Average)
On the other hand, a P/E ratio lower than market averages could indicate an undervalued stock. Stocks with low P/Es are often mature companies with sustainable sales and frequently appear in value-investing strategies.
But, like high P/E stocks, context is required. Utility companies almost always have low P/Es because regulation limits their profits, not because they have undervalued stocks.
Comparing P/E Ratios Within Industries
Metrics like P/E ratios need a baseline for comparison, and the best benchmark is usually competing firms in the sector. For example, tech stocks focused on growth might have P/E ratios that exceed market averages because they trade on potential, not sustained profits.
Comparing the P/E of a fast-growing tech firm to consumer staples stocks won’t provide much helpful information. Instead, compare NVIDIA Inc. (NASDAQ: NVDA) to other semiconductor stocks and Proctor and Gamble Co. NYSE: PG to other consumer staples companies.
Limitations of the P/E Ratio
P/E ratios are helpful but not flawless. Just as smoke doesn’t always mean fire, a high P/E doesn’t always mean an overvalued stock. Consider these limitations when applying P/E to your analysis:
- P/E struggles to account for growth. A stock with a high P/E could experience exponential growth that justifies the high valuation and creates outsized returns for investors.
- Creative accounting can deflate P/E ratios. Just because a stock shows a low P/E ratio doesn’t mean you can forgo examining the company’s financial documents.
- If a company doesn’t earn profits (or loses money), the P/E ratio will be useless in evaluating that particular firm.
How to Use the P/E Ratio in Investing
As with any stock research tool, the P/E ratio is best used in combination with other evaluation metrics and historical context. Here are three actionable ways to use P/E:
- Compare stocks in the same sector or to the sector average as a whole. Comparing companies with similar business models and products will produce a more accurate analysis.
- Other valuation metrics, such as price-to-book (P/B) or price-to-earnings growth (PEG) rates, can help form a more comprehensive view of the company’s financials.
- Historical trends can also provide helpful comparisons. Is the stock trading above or below its long-term P/E averages?
No investment research tool is an island. Even straightforward metrics like P/E ratios must be used with other stock valuation tools to make informed decisions and avoid mistakes. The P/E rate provides a nice snapshot of a company’s financial foundation but little more than that.
To produce actionable ideas, investors must use other metrics like P/B and PEG rates, too, along with comparisons to sector competitors, long-term industry averages and the company’s historical performance. Remember, a low P/E ratio stock isn’t automatically an undervalued gem.
Always consider fundamental factors and economic data when investing in stocks for long-term goals.
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