When investing in stocks, traders use many different financial metrics to try to gauge if a stock is a good buy or not. Most stock traders will have heard of the price-to-earnings ratio (P/E ratio). The measurement casts an important light on how much a company should be valued and whether the company is doing well from a profitability standpoint.
At its root, the P/E ratio helps you understand if a market is overvaluing or undervaluing a stock. The tool offers a handy way to compare and contrast different stocks from the same industry on a major index, such as the NASDAQ or the S&P 500.
In this article, we will discuss the P/E ratio in greater depth by offering you common methods of calculating the P/E ratio across several stocks. This, in turn, will help you make better investment decisions.
What is the P/E Ratio?
The P/E ratio is a popular measurement that allows stock traders to compare the market share price of a company with its earnings per share (EPS). This relationship is important to know because, once you understand it, you can simply and effectively decide how much you are willing to pay for a company's stock.
Here is an example of a P/E ratio in real life. At the time of writing, Apple's share price was $175.16. Apple's diluted EPS for the prior twelve months ending in March 2023 was $5.89. This means that Apple's PE ratio for today is 29.74.
However, in early 2020, driven by huge consumer goods demand from people having to work from home during COVID, the company’s P/E ratio stood at a healthy 35.24. By contrast, in 2009, just a year out from the global financial crisis, it was at a lowly 16.94. In this context, we can see that today’s P/E ratio for the company is moderate to good by its own historical standards.
How do you calculate the P/E Ratio?
You can arrive at a final P/E ratio by dividing the market price of a share by the earnings per share of that stock. The market price per share is simply the present price at which the stock is trading. The EPS is a number that measures the firm’s net income divided by the number of shares in circulation.
Thus, the P/E ratio looks as follows:
P/E Ratio = Market Price per Share / Earnings per Share
How Do You Use The P/E Ratio?
It’s important to mention that, like many measures in the trading world, the P/E ratio is one number that gives a small insight into a share’s performance. It is not a magic bullet that, when deployed, gives you everything you need to know about whether to buy or sell a stock. No such measure exists. Every measurement in the stock trading world gives just a little bit more information. The trick is to combine several different measures to arrive at a holistic picture of the value of the share, and even then you could get it wrong!
How you view the P/E ratio depends heavily on the industry and trading environment in which a company operates. As a rule of thumb, a higher P/E ratio indicates that investors have higher expectations for future earnings growth. Using our Apple P/E ratio, we can see that the P/E ratio was depressed after the global financial crisis, received a boost during COVID, and is presently weakening due to inconsistent global demand.
Naturally, a lower P/E ratio suggests a stock may be undervalued, indicating that investors have lower expectations for future earnings growth. Remember that what is low for a tech company may not be low for a chemical company, so always view P/E ratios respective to industry peers. That said, if a P/E ratio is simply too low, it could mean there are fundamental issues with the company’s growth prospects.
What Do Investors Expect From P/E Ratios?
Generally speaking, a healthy P/E ratio hints that investors are expecting higher earnings growth in the future compared to firms with a lower P/E. A depressed P/E can mean either that a company’s stock is undervalued. It is hard to understand how to treat a brand-new stock that has no significant P/E trend history. This is because a P/E trend must be viewed contextually and in relation to a stock’s own history and in terms of how it is doing against peers. A company can even be in the red, leading to its P/E being expressed as a negative, but this is not the common convention.
When studying a P/E ratio, you can use historical measurements to your advantage. When they have been trading for several years, all stocks can be given a standardized measurement. This is simply the median of their P/E ratios over a period of several years. You could use this as a benchmark for a stock’s performance in both up and down cycles, which could help you decide if a stock is worth buying or if it is time to sell.
Limitations of Using the P/E Ratio
As we have said, the P/E ratio is not a magical formula. It must be viewed in conjunction with a range of other market signals. Some of the most common limitations of the P/E ratio are as follows:
Companies that aren't profitable and have a negative earnings per share present a challenge when trying to understand their value. Many startups are not profitable initially, even if they have a bright future based on the problem they are solving. This makes the P/E ratio a useless tool in instances like this.
By the way, unprofitable companies are not rare. Rivian, the maturing American electric vehicle company, has been “burning cash” for three years as it scales up its production facilities. It currently has a negative P/E ratio, but analysts are excited about its future as it has signed a partnership deal with Amazon, and it has a large, unfulfilled order book.
Another limitation of the P/E ratio comes when traders attempt to compare P/E ratios across industries. Valuations and growth rates of companies may often vary greatly among sectors due to both the different ways companies earn money and the differing timelines during which firms make that money.
This is why P/E is best used when considering companies in the same sector. If you were to compare the P/E ratios of a pharmaceutical company and an energy company, you could be led to believe that one is a better investment than the other, but this assumption would be flawed.
The Bottom Line
Remember that the P/E ratio is just one of many factors to consider when evaluating stocks. It should be used in conjunction with other fundamental and technical analysis tools to make informed trading decisions.
However, it is a good place to start. If you are well informed about the P/E ratio of your favorite firms, you could use any movement up or down as a kind of shorthand for the company’s prospects. You would still need to perform more detailed analysis, but using the P/E as a headline indicator could be a timesaver.
FAQ
What is the P/E ratio?
The P/E ratio is a financial measurement used to judge a firm's valuation by comparing its stock price to its earnings per share. It is calculated by using a common equation that divides the stock price by the EPS.
Is the P/E ratio useful for stock traders?
Yes. The P/E ratio provides insight into how much investors are willing to pay for each dollar of earnings generated by a company. It can be useful, but there is a healthy caveat in play which is that it is not a magic pill. The P/E ratio can help traders assess the relative value of a stock when compared to its peers. This exercise can identify potentially overvalued or undervalued stocks.
What does a high P/E ratio indicate?
A high P/E ratio suggests that investors are happy to pay a premium for the company's earnings. It generally means that analysts and the market have high expectations for future growth. It could also mean that the stock is overvalued because sometimes high expectations are not grounded in objective facts. A high P/E ratio alone does not tell the full story. More analysis is required.
What does a low P/E ratio indicate?
A low P/E ratio suggests that the stock is poorly-priced compared to its earnings. This could be from it being undervalued, or it could also suggest that the prospects of the firm are not positive based on underlying performance issues. Like a high P/E ratio, a low P/E ratio alone should not be the sole basis for investment decisions.
How does the P/E ratio vary across industries?
Different industries can have vastly different P/E ratios due to their respective growth rates, risk levels and profitability. Some industries, such as technology, often have higher P/E ratios due to their potential for exponential growth, while industries such as commodities may have lower P/E ratios due to their stable growth patterns.
What Is a Good P/E Ratio?
This really depends on the industry in which the company is operating. Some industries naturally have higher average P/E ratio due to their growth potential, while others will have low ratios. For example, it is not uncommon for industrial manufacturing firms to have an average trailing P/E ratio of below 20, compared to more than 60 for software companies. If you want to get a handle on whether a P/E ratio is high or low, you should compare it to the average P/E of the competitors within its industry.
Is It Better to Have a Higher or Lower P/E Ratio?
A common answer to this is that it is better to buy shares in firms with a lower P/E ratio because you are paying less for every dollar of earnings that you get. A lower P/E could be viewed as a lower price tag, making it attractive to shoppers looking for a bargain. In reality, you must understand the reasons behind a company’s low or high P/E. It could be that a company has a low P/E ratio because the need for its products is declining, as opposed to its being a bargain waiting to be snapped up. So, there is no simple answer to this question. P/E ratios are company-specific and industry related.
