What is Price-to-Earnings (P/E) Ratio

In this article we’ll take an in-depth look at P/E ratios and how they can help with your investment journey.

Whether you’re new to investing or an experienced investor looking to maximize your returns, price-to-earnings ratio (P/E ratio) is an important financial term to know. A P/E ratio compares a company’s current stock price to its historical earnings per share. P/E ratios are also commonly known as a price multiple or the earnings multiple. A P/E ratio uses simple mathematic calculations to provide both investors and analysts with the ability to determine the fair value of company or other companies.  

What is a price-to-earnings ratio?

A P/E ratio compares a company’s stock price against its earnings per share. There are two types of P/E ratios that are used to evaluate a stock, trailing and forward. Using historical data, investors can calculate a trailing P/E ratio, this is the most frequently used P/E ratio. A trailing P/E ratio allows you to understand how a company’s common price is relative to its earnings per share.

If you’re interested in determining how a stock may be valued in the future, a forward P/E ratio may help provide you with the answer. A forward P/E ratio uses forecasted earnings per share over the next 12 months to calculate a price-earnings ratio.

Whether you’re calculating for trailing or forward P/E ratios, the result will be a number that you can use to evaluate each company. On average P/E ratios range from 20 to 25 points. You may be wondering what’s the difference between a high or low P/E ratio and what information can be learned from each figure.

High P/E Ratios

A high P/E ratio happens when investors drive up the share price, but a company’s earnings remain low. This could mean that the stock is overvalued or that investors feel that the company is not yet at it’s peak and still has significant growth potential. Any P/E ratio above 25 would be considered high.

Low P/E Ratios

A low P/E ratio could suggest volatility in the market and occurs when investors are losing confidence and selling shares which in-turn would reduce the share price, while earnings remain unchanged. In addition, a low P/E ratio also occurs when a company’s earnings quickly outpace expectations before investors can buy shares and increase the stock price. Any P/E ratio below 20 would be considered low.

How to use price-to-earnings ratio?

One important reason why P/E ratios are so commonly used is because they provide investors and analysts with a statistical basis for evaluating a company and its stock prices.

A P/E ratio can help you understand:

• Whether a stock is fairly priced, overvalued or undervalued
• How much you are paying for each dollar of earning on a share price
• How a stock is valued compared to its industry group or against an index

What is a good P/E ratio?

There’s no benchmark value that can be assigned to a good P/E ratio. Both high and low P/E ratios can be beneficial to your investment strategy because they provide insight into how the company is being valued. A high P/E ratio means that you are paying more for each dollar per earnings and the opposite can be said for a low P/E ratio, however it is only one aspect of stock valuation.

How to calculate P/E ratio?

When using a P/E ratio to evaluate a stock price it’s important to first determine which ratio you’re interested in finding. [MJ4] Below is an example and the detailed formula necessary to help you calculate each unique P/E ratio.

How to calculate a trailing P/E ratio

To determine a trailing P/E ratio, you must take the current share price and divide it by the earnings per share for the past 12 months.

Trailing P/E Ratio = Current Share Price / Trailing 12-Month Earnings Per Share

For example, if company A has current share price of $75, and the 12-month trailing earnings per share is $5, then the trailing P/E ratio is 15x. This means the stock of company A is trading at 15x it’s trailing 12-month earnings.

How to calculate a forward P/E ratio

To determine a forward P/E ratio, you must take the current share price and divide it by the forecasted future earnings per share for the next 12 months.

Forward P/E Ratio = Current Share Price / Forecasted 12-Month Earnings Per Share

For example, if company B has a current share price of $25, this year’s earnings per share are $10 over the next fiscal year, the company has P/E ratio of $25/10 = 2.5x.

Conclusion

It’s important that you do your due diligence while investigating P/E ratios. Remember that while P/E ratios can provide an impressive snapshot to evaluate a company, it’s still crucial that you conduct extensive research to gather a complete picture about how company is doing. Be sure to compare a company’s P/E ratio to others in the industry and use other stock valuation models before you make a final investment decision.