Price-to-Earnings (P/E) Ratio Definition and How to Use it

Investing
Updated: 8th Oct 2021
Written by Parker Pope
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October 8, 2021
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What is Price-to-Earnings (P/E) Ratio?

The P/E ratio compares a company’s stock price with the earnings per share of a company in a given fiscal quarter.

P/E ratios are commonly used as valuation metrics to determine if a company might be over or undervalued.

Investors typically compare the P/E ratios of similar companies to potentially see if a given stock trades at a discount or premium to its peers.

Understanding the Price-to-Earnings Ratio

A low P/E ratio doesn’t always mean a company is mispriced or undervalued. It might be low because it’s a bad company and it’s losing market share. The opposite is also true.

However, P/E ratios provide some type of normalized standard to compare one stock to the next. This can be useful when trying to identify investment opportunities.

The P/E can also be effective at telling you what the current valuation of a company’s earnings shows, but it requires context to truly understand whether the company is a good investment to buy into or to keep holding.

How to Calculate the P/E Ratio

The price to earnings ratio is a very simple calculation that starts with a company’s stock price.

It might then make logical sense to divide that by its earnings, but it’s not that simple.

“Earnings” refers to the earnings per share reported by the company. With that said, the P/E ratio is the current stock price divided by the earnings per share reported in the earnings statements.

This is where the “apples to apples” comparison comes into play. To have a correct ratio, you need to make sure the P/E ratio compares stock price to the earnings per share.

Comparing the stock price to a company’s total earnings is not a very accurate metric because not only would it be a ludicrously small number, but it also does not take into account the size of the company relative to its earnings.

Using earnings per share normalizes each ratio, which allows them to be comparable.

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How to Use P/E to Value Stocks

P/E ratios generally allow investors to compare the current valuations of multiple companies at once with relative ease.

Investors can line up and compare several stocks at once by using their P/E ratios to see how expensive each stock is, relative to its earnings, at that particular time.

There are actually three different P/E ratios recognized in the industry:

  • Trailing Twelve Month (TTM) Earnings – This takes the last twelve months of earnings and uses this instead of only the current quarterly earnings.
  • Forward Earnings – This method is less accurate than the TTM above, which is more widely used, but still provides an estimate of what the market thinks the forward earnings will be.
  • The Shiller P/E Ratio – This method uses an average of a company’s earnings over a period of time. It’s fairly complicated and includes earnings over a ten-year history, but it’s also inflation-adjusted. While very accurate based on past performance, it’s less difficult when so many popular companies these days don’t have a lengthy history, so it limits the playing field to older companies.

Price-to-Earnings FAQs

What is a good price-to-earnings ratio?

For those trying to buy companies at a good (low) price, a lower P/E ratio is generally better. In most cases, a P/E of less than 10 could be a good indication of a company that is priced low compared to its earnings. It does not necessarily mean that company is a great deal, however. It depends on the industry and a variety of other factors.

Is a high PE ratio good?

That entirely depends on your investing style and the company. If you are strictly focusing on value investing, buying a company with a high P/E ratio would not be a good idea.

However, growth stocks like Palantir typically have extremely high P/E ratios, or actually none at all, because they’re unprofitable and therefore do not have a number to put in the denominator. That doesn’t mean the company is overvalued. It could simply indicate that the market expects the company to see above-average growth for the foreseeable future.

Is it better to have a high or low PE ratio?

Again, it really depends on the style of investing that you are trying to employ. A high P/E ratio is not necessarily a good or bad thing, and the same goes for a low P/E.

It’s really more important to figure out what specific strategy you’re employing and use the P/E ratio to possibly help you target the stocks that fit that strategy.

Remember that a low P/E ratio points to a company’s stock price being low compared to their earnings, but that could be the market telling you that the company isn’t expected to be successful in the near future.

Bottom Line: Price-to-Earnings (P/E) Ratio

The price to earnings ratio is an indicator of how its stock price compares with its earnings per share.

It provides investors with a good way to compare the valuations of companies side by side while also deciding whether the valuation of the stock makes it a good investment.

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Parker Pope
Parker Pope
Parker has spent over 10 years studying the financial markets. He currently manages his own portfolios by trading options and futures, and he’s excited to share his experience with those interested in a hands-on approach to their investments. No fancy tricks or indicators, just a commitment to understanding risk management and knowing the “why.” While he invests actively, he’s built a wealth of knowledge about personal finance and commits his efforts to writing about topics to help people take control of their finances.