If you’ve ever spent any time around career investors, or even those who are relatively new to the investing game, you’ve probably heard the phrase “P-to-E ratio” or “price-to-earnings ratio” thrown around with some level of excitement.
But if you’re unfamiliar with all the complicated jargon that is so common among investors and financial experts, this phrase is probably pretty meaningless to you. But it must be awfully important to garner so much enthusiasm from apparent experts, right?
In this article, we’ll do our best to answer that question and many others as they arise. We aim to provide you an easy-to-grasp P/E ratio definition, a quick primer on how to calculate P/E ratios, a full understanding of why P/E ratios are important in investing, and a discussion of what a good P/E ratio might be.
But first, a warning: this topic can get a bit technical and difficult to wrap your head around. For one thing, there are several critical terms that are very easy to misconstrue. And to make matters even more confounding, there is widespread disagreement regarding the importance of P/E ratios in general. So, it might be something of a challenge to truly nail down this concept and its applications.
Not to worry, though; we’re here to help you make sense out of all this thorny economic material and even show you how you can apply this new knowledge to improve your own investment strategies.
Let’s get to work!
What Is P/E Ratio?
P/E ratio is a shorthand way of saying the price-to-earnings ratio. It is one way in which investors and other interested parties can determine the value (a process known as “valuation”) of a particular company’s stock. More specifically, it is the ratio of the current market value of a single share of a company’s stock relative to that stock’s earnings-per-share (EPS).
Whoa! Let’s take a couple of steps back for a second. Obviously, before we can make any sense out of that definition and really understand P/E ratios, we first have to provide a foundation by explaining these new terms.
So, what do we mean by “earnings-per-share” and a stock’s “market value”? Let’s consider each term in some detail.
Market Value Per Share
This first one is easy, and you’re probably already pretty familiar with the concept, even if you don’t recognize the terminology.
Simply put, the market value per share of a particular stock is just that stock’s market price. That is, the market value per share of a company’s stock is the amount of money you would have to pay in order to purchase one share of that company’s stock.
These are the prices that you see when you look at a stock exchange ticker. Those prices refer to the current cost to buy a single share of stock in a given company.
Earnings Per Share (EPS)
While understanding the concept of market value per share is straightforward, earnings per share (or EPS) can be a bit more difficult to comprehend, though the idea behind it is actually pretty simple.
In essence, earnings per share is a firm’s total net income divided by the number of shares there are of common stock for that firm.
So, to use a radically oversimplified example, think of a firm that posted earnings (net income) of £1 million in the past twelve months. Now, suppose that firm has 100,000 shares stock on the market. Finally, all you have to do to figure out this firm’s earnings per share is to divide that £1 million by the 100,000 shares, leaving you with earnings per share of £10.
Now, of course, the reality of calculating earnings per share for an actual firm is far more complicated than this. To be completely accurate, basic earnings per share is calculated by this more detailed formula:
EPS = (Net income – preferred dividends) ÷ the weighted average of outstanding shares
But this is really beyond the scope of our little crash course. You should be just fine as long as you simply remember that earnings-per-share is net income divided by the number of shares.
How to Calculate P/E Ratio
Now that we have the general concept of P/E ratio explained, we need to move on to the more abstract, mathematical side of the issue. That is, we need to nail down a workable formula that will allow us to actually calculate the P/E ratio for any given stock.
Luckily, the math is rather simple. We’ll offer you the basic formula first, and then we’ll go into more detail about how it works, what each of the elements of the formula refer to, and also provide a couple of practical examples. So, here’s the standard formula:
P/E = Market Value Per Share ÷ Earnings Per Share
Pretty easy, right? So let’s take an example: if a firm’s stock has a current market value of £25 per share (that is, it costs £25 to purchase a single share of that firm’s stock), and the firm’s earnings are given as £5 per share, what is the P/E ratio?
Right! P/E = £20 ÷ £5.
So, the P/E ratio of our imaginary firm’s stock is 4.
For our purposes now, we won’t go into whether that is a “good” or a “bad” P/E ratio. Instead, just take a moment to appreciate the fact that you now know how to calculate a P/E ratio!
What Does P/E Ratio Tell You?
If you are attempting to value a particular stock, that stock’s P/E ratio can tell you some useful things to help you determine that value.
In a sense, the stock’s P/E ratio can give you some understanding of how attractive the market thinks that stock is, in light of the firm’s past or predicted future earnings.
But P/E ratios can tell you much more than this kind of information on individual stocks.
Indeed, if you consider the average P/E ratio of all of the firms within a particular industry, it can give you valuable information on where that industry is as a whole. The important thing to take into account when considering industry-wide P/E ratio averages is how those industry averages compare to historical P/E averages.
Generally speaking, when the industry P/E average far outpaces the historical average in one direction or another, it tends to signal major changes in the industry and may even suggest general volatility. As always, do lots of research on these issues to make the decision you feel most comfortable with. Or, better yet, have a good discussion with a quality financial advisor or other investment expert and see how your instincts and intuitions compare with theirs.
Is There Only One Kind of P/E Ratio?
After all that information, you are probably feeling a bit overwhelmed, but you hopefully have a more solid understanding of the P/E ratio definition, how to interpret a P/E ratio, and how to calculate it.
Unfortunately, there’s some bad news: P/E ratios get more complicated still.
Indeed, there are several different varieties of P/E ratios that vary depending on the types of earnings included in the calculation and how those earnings are calculated to begin with. But there are two key variations on P/E ratios that are the most common in finance. Let’s take a brief look at each one and see if we can make some sense out of this.
Trailing P/E
This version of the P/E ratio is the most frequently used in investment discussions. In fact, it’s so prominent that when people simply say “P/E” or “P/E ratio” without any additional qualifiers, it is usually trailing P/E that they are referring to.
Trailing P/E refers to a P/E ratio that is calculated by dividing the current market value per share by the aggregate earnings per share from the previous twelve months. It’s this timeframe that distinguishes trailing P/E from other kinds of P/E calculations. That is, trailing P/E is a measure of P/E that only takes into account a firm’s past earnings performance.
This might seem pretty intuitive, and that’s because it is. This is why trailing P/E is so commonly used be investors and economists alike. Indeed, many experts consider it to be the closest thing to a truly objective measure of P/E because it is based on the actual reported earnings of a company.
But as with every economic model and metric, trailing P/E has certain drawbacks. The most significant problem with basing P/E calculations on past quarterly earnings is simple: how well or poorly a company performs in the past is by no means a fool-proof—or even particularly reliable—indicator of how that company will behave and perform in the future.
This is a problem for quite obvious reasons: if the point of investing in the stock market is that you expect the value of that stock to appreciate in the future, then a good investor would invest her money based on metrics that do anticipate future behaviors and positive performance.
Forward P/E
As you might expect, while trailing P/E uses past earnings to calculate the ratio, forward P/E uses estimates of future earnings to make the calculation. To be more technically accurate, forward P/E calculations use “future earnings guidance” for the earnings per share part of the formula.
The ways in which economists, executives, and financial analysts determine this future earnings guidance is incredibly complex—too complex, indeed, for us to make any real sense out of it in the limited space we have available here.
Yet, I think most people will intuitively see the potential shortcomings inherent in this kind of calculation. To put it bluntly: no one can predict the future. And if no one can definitively predict the future, then no one can definitively predict how a company will perform with regard to future earnings.
Of course, there are incredibly intelligent and skilled experts who have spend their whole careers finding ways to make these predictions as accurate as possible, and they often get it right. But “often” is still pretty far from “always,” so, as with any economic or financial metric, you should consider forward P/E ratios with a big pinch of salt.
Why Is P/E Ratio Important?
The main reason that P/E ratios are important to investors and financial analysts alike is that this ratio helps them determine if a stock’s value is “correct.” That is, P/E ratio is a metric that helps inform investors if a stock is valued too highly (overvalued) or valued to low (undervalued).
In other words, a P/E ratio can be a useful tool to help investors decide whether or not a stock is a good buy, or “worth it” to them. But, as we’ll continue to drill down again and again in this article, no financial or economic metric is fool-proof, and there are likely just as many investors and experts who completely disregard P/E ratio as a means of determining a stock’s potential value as there are those that swear by it.
Read More: 5 Crucial Steps To Understanding The Stock Market
What Does a High P/E Ratio Mean?
If a stock has a high P/E ratio, it could be an indicator of a couple of different things.
For one, a high P/E ratio can indicate that a stock’s market value, or price, is disproportionately inflated with regard to the company’s earnings. In other words, a high P/E ratio can suggest that the market has placed too high a value on that stock, given the company’s sub-par earnings, perhaps.
But this isn’t always the case. For instance, it is not uncommon for tech companies to fetch seemingly overvalued market prices relative to their earnings. And yet, most well-informed investors and financial experts agree that many of these tech companies are not, in fact, overvalued. Why would this be the case?
Generally speaking, in our current economy technology companies have a strong tendency to grow at a much more rapid rate than companies from most other markets. The reason for this rapid rise in market value, despite the fact that tech companies very rarely boast impressive earnings early on, is that investors recognize that tech companies have this great potential to grow quickly.
A great example of this is Amazon.
As of this writing, Amazon’s P/E ratio is at 79.50 times earnings. Compare that to the current average P/E ratio in the market, which hovers around 23 times earnings, and you can see how high the P/E ratio of a major tech firm can get. But the point is, you’d be hard-pressed to find a financial expert who things Amazon is a bad investment that won’t (continue to) produce mammoth returns on investment.
So, ultimately, investors don’t mind paying more for their tech shares in the short-term because there is such great potential for return on investment through the rapid growth that tech companies are so well-known for.
So Which P/E Ratio, High or Low, Is Better?
Here we come again to that most frustrating answer in finance and economics: it depends on a variety of interconnected factors. Yes, it’s annoying, but if picking out the best deals on stocks was a simple and straightforward task, we’d all be making billions doing it!
As we just discussed, a high P/E ratio could signal a good investment in cases like big tech companies with great potential for growth. On the other hand, sometimes when a firm’s earnings are falling more rapidly than its stock price, its P/E will go up. In this case, a higher P/E ratio would almost certainly not suggest a good investment.
Typically, though, stocks with lower P/E ratios are going to be safer investments. After all, a low P/E ratio means that a stock’s market value is roughly keeping pace with earnings. In a perfect world, this would always signal a good investment because, intuitively, we tend to think that a firm’s market value should reflect that firm’s earnings.
Of course, it’s always more complex than that, so be sure you consistently do diligent and thorough research on any stock before you buy, whether it has a high P/E ratio, low P/E ratio, or a P/E ratio somewhere in between.
Why Do Some Stocks Not Have a P/E Ratio?
You may have noticed that some stocks don’t have P/E ratios. Often, these stocks simply list N/A for their P/E ratios. What does that mean?
Well, for starters, “N/A” simply means “not available” or “not applicable.” And the possible reasons that a company’s stock might have N/A listed instead of a P/E ratio are twofold.
On the one hand, a blank or N/A listing for a stock’s P/E ratio can mean something completely innocuous: there really wasn’t any available information to determine a P/E ratio when the report was made. Sometimes this is the case for companies who have just recently been listed as an IPO. The basic reason for this is that these fresh, new companies have not been around long enough to have produced any report on their earnings. Thus, with no earnings to report, there is no way to calculate a P/E ratio for these companies.
More often, though, the cause of a company’s stock not having a P/E ratio listed is that, for some struggling companies perhaps, calculating their stock’s P/E ratio would produce a negative value. But why should this be an issue when it comes to reporting the P/E ratio?
That’s a bit harder to say, but the short answer is that the community of investors and financial analysts and experts simply don’t accept negative values for P/E ratios.
But let’s dig into this a bit more.
Think: if the ratio of a company’s share price to its earnings per share can produce a negative value, what has to be true about one of those metrics?
Right, one of them has to be negative. And since you can’t have a negative share price, that means that the negative P/E ratio has to be caused by negative earnings per share. In other words, a company’s stock can only produce a negative P/E ratio if they have posted losses in the previous twelve months (or, perhaps even more troubling for the company) they are expecting or are expected to post losses in the future. Either way, it’s clear that a negative P/E ratio doesn’t spell positive things for the future of that company!
The S&P 500 P/E Ratio: What Does It Tell Us?
In short, the S&P 500’s P/E ratio provides essentially the average P/E ratio for all of the stocks within that market. So, in a sense, this P/E ratio is the P/E ratio of the market itself. Investors often look to the market P/E ratio to gauge general trends in the market, helping them sus out whether stocks overall might be undervalued (i.e, the best time to purchase stocks) or overvalued, which might suggest those stocks will begin to decrease in value in the near future.
Read More: How To Get Started With Investing In 2020
The Bottom Line: Are P/E Ratios Valuable Guides for Assessing Stocks?
Now that we’re at the end, we get to leave you with one last, assertive…maybe. As we’ve discussed at length, there are simply too many variables to give a full-throated yes or no on that question.
Can P/E ratios be useful metrics and tools for helping you determine the value a stock might have for you in the future? Most definitely. But are there still plenty of significant limitations to the value that these ratios can provide? Certainly.
While you should always gather as much information about a stock—or any investment, for that matter—sometimes you have to follow your intuition. Buying stocks isn’t about simply buying up the cheap ones. Cheap stocks can sometimes be dismal investments.
The point is, there is far more that goes into a successful company that will lead to lucrative returns on investment than you can ever elicit from hard metrics alone.
Consider a firm’s culture, it’s business practices, it’s management, it’s marketing strategies—literally, every piece of information you can obtain about a company can be potentially helpful to you as you continue your search for the ideal investment for you.
Sources
“Price-Earnings (P/E) Ratio” Investor.gov – https://www.investor.gov/additional-resources/general-resources/glossary/price-earnings-pe-ratio
“What Is a Good P/E Ratio?” Yahoo! Finance – https://finance.yahoo.com/news/what-is-a-good-pe-ratio-200046888.html
“Price-to-Earnings Ratio – P/E Ratio” Investopedia – https://www.investopedia.com/terms/p/price-earningsratio.asp
“Everyone still relies on a stock’s P-E ratio to invest, but a study shows it’s bunk” CNBC – https://www.cnbc.com/2019/05/31/everyone-still-relies-on-a-stocks-p-e-ratio-to-invest-but-a-study-shows-its-bunk.html
“Price Earnings Ratio” Corporate Finance Institute – https://corporatefinanceinstitute.com/resources/knowledge/valuation/price-earnings-ratio/
Investments in Shares – https://sites.google.com/site/investmentsinshares/home
